Has the Fed short-circuited yuan falls?

See the latest Australian dollar analysis here:

Macro Afternoon

From Macquarie:

 The latest FOMC meeting turned more dovish, as Fed officials now expect 2 rate hikes by end-2016, compared with 4 last Dec. In the statement released after the meeting, the FOMC also added a new sentence, “Global economic and financial developments continue to pose risks.”

As the result, it could help lower the short-term depreciation pressure on the RMB, although risks remain in the medium term.

Understanding the RMB: One driver and two principles

 In a nutshell, our way of observing the RMB is very simple: The strength of dollar leads the movement of USD/CNY, while the PBoC follows two principles: (1) If the dollar index strengthens, the RMB would depreciate against dollar along with other currencies; (2) If capital outflows are too high (say, close to $100bn a month), the PBoC would step up intervention to stabilize the currency and reduce capital outflows.

 As such, we believe the dovish stance adopted by the Fed in the latest FOMC, and thereby a weak dollar, could help lower the depreciation pressure on the RMB and China’s capital outflows. This is a positive development of international policy coordination since the recent G20 meeting in Shanghai. Two scenarios are possible:

 A positive one: Weak dollar -> stable RMB -> lower capital outflows from EM – > higher risk appetite globally -> weaker dollar. It’s a positive feedback loop, but it requires policy coordination between China and the US. China needs to be clear about no major devaluation, while the US needs to mind the strength of the dollar as the result of its policy moves.

 And a negative one: Strong dollar -> weaker RMB -> higher capital outflows from EM -> lower risk appetite globally -> stronger dollar. It’s a negative feedback loop. In the end, it could force the Fed to postpone rate hikes, as rising market volatility and a strong dollar could hurt the recovery in the US.

Not time for complacency: Stability could lead to instability

 The PBoC must feel lucky recently. Surprisingly, the recent easing by the BoJ and the ECB was followed by stronger Yen and Euro against US$. Yesterday’s FOMC further weighed on the broad force of US$. As the result, the CFETS index, a trade-weighted RMB exchange rate against a currency basket tracked by the PBoC, dropped to the lowest level since Nov 2014. However, it’s not the time to feel complacent on the RMB, because stability could cause instability. In other words, an improved global macro environment and robust domestic data could prompt the Fed to consider more hikes in months ahead, which would cause dollar to strengthen again.

That summarises my own views nicely. China needs to devalue to soften its growth transition. The US is going well enough that it still wants to, or may need to owing to inflation, tighten further. The same tension has already smashed commodity markets to bits which is threatening to overwhelm both by triggering a full blown Mining GFC and global recession.

I remain of the view that this current rally is hiatus not a change in trend. In the end, even if the Fed was to stop raising rates altogether and the US dollar was to fall, taking pressure of the yuan, China will still slow and commodity prices (especially the bulks that matter to Australia) will still resume falling on oversupply.

That will make life very difficult for Australia as the Aussie dollar falls more slowly than commodity prices, but it will still fall as it rains rate cuts on the ongoing terms of trade reversion to mean.

David Llewellyn-Smith
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