China Surprises, Mini-Devaluation, USD Mostly Firmer

Chinese officials surprised the market by instituting a mini-devaluation of the yuan.  The 1.9% move was signaled by announcing the highest dollar fix in two years.  Officials indicated that this was a one-off move in response to the appreciation of the real exchange rate.  At the same time, it injected CNY50 bln through a seven-day repo operation, which offset part of the CNY85 bln of maturing repo and bills. 

With the dollar appreciating against a broad range of currencies and the the yuan for all practical purposes, pegged against the greenback, of course, it appreciated on a trade-weighted basis.  This move comes on the heels of weak exports and non-food prices.   There are three orders of impact that investors are contemplating.  

First is the effect on the Chinese economy itself.   Given that the value-added in China of much of its  exports is still fairly limited to 20-33%, today's depreciation is unlikely to have a perceptible impact on the competitiveness of China's exports.   In terms of China's financial conditions, the devaluation is likely to be reinforced with other easing measures, like a cut in required reserves or interest rates.    The gap reported today between new yuan loans in July (CNY1.48 trillion), and the aggregate financing (CNY718.8 bln) likely reflects the funds used to arrest the slide in equities.  

Although China's move was not telegraphed and is clearly in response to recent developments, it does not appear to be panicking or simply a move out of weakness.  It is a vote of confidence in the ability of the financial market to absorb it.  Also, it is not particularly concerned about rising the debt servicing costs of the numerous China's corporates who borrowed dollars.  

The second order of effect is on commodity markets.  The depreciation of the yuan sparked a retreat in commodity prices.   Losses are not very steep but are broadly felt, through the industrial metals and energy.  Gold is about 0.8% higher. 

The third order of effect is on the financial markets.  The dollar-bloc and emerging market currencies are bearing the brunt.  The antipodeans are off 1%.  The Australian dollar is posting an outside day, having initially risen above yesterday's highs and then sold-off below yesterday's lows.  It held  above $0.7300, well above the multi-year low set at the end of July near $0.7235, it has threatened what had appeared to have been corrective forces.   The Canadian dollar is off half as much.   The US dollar found support just below CAD1.30. 

The euro and sterling initially well, but both recouped those losses to move higher, extending yesterday's recovery in the European morning.  There was talk of leveraged accounts unwinding short euro carry positions that had been established against the yuan.   The more in the offshore non-deliverable forward market, strictly a function of supply and demand moved twice as much as spot (12-month NDF). 

Global bonds have rallied.  The US 10-year Treasury is off 7 bp  to 2.15%.  We note that the 200-day moving average is near 2.14%.  European bond yields are off most around 5 bp, with the gilt yield off 8 bp.  News that an agreement with Greece will be ready for the Greek  parliament to vote on in time for the Eurogroup meeting on Friday has helped Greek bonds rally, with the 10-year falling back below 10%.  Greek stocks are also bucking the losses in equity markets.  Athens is up about 2.5%, led by financials with twice the gain.

Some attributed yesterday's dollar retreat to comments by Fed's Vice Chairman Fischer, who seemed to emphasize the low inflation rather than the recent constructive jobs data.    We think this was largely stylistic, and that Fischer did not deviate from the Phillips Curve understanding that absorption of slack in the labor market will lift inflation over time.  He also recognized that most of what is dampening inflation is of a transitory nature.  We note in this context that the September Fed funds futures was unchanged on the session, and the two-year note yield was 0.5 bp higher despite the gains in the equity market. 

The PBOC also announced a change in the setting of the central reference rate (the fix).  Going forward, it will be more influenced by the previous close (in Shanghai) and subsequent changes in the other currencies.   This is potentially important from an operational point of view, especially in light of the work that needs to be done to be included in the IMF’s SDR.  However, like much in China, the actual practice may deviate from what appears to be the declaratory policy.   There is a great deal of uncertainty about what happens next, and investors will monitor the situation closely. 

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