The Week Ahead: Shadow and Light

Foreign Exchange: The Week Ahead
Shadow and Light
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
This past week, the PBoC lowered its required reserve rate ratio by another 50 bps. This move should free up around 800 billion yuan (~$115 billion) of liquidity into the markets and comes at a time when domestic liquidity conditions have become a concern due to the Chinese government's crackdown on unregulated lending aka shadow banking. Shadow banking is a vast network that consists of thousands of financial entities, including regular banks, which use shadow banking assets as a way to circumvent lending regulations. To better understand shadow banking and its risks, we have summarized the key sources of shadow banking funding below.

Asset Management Products (AMP)

AMPs represent the largest source of funding (~40%) for shadow banking loans. In essence AMPs are high-yielding deposit accounts. Because there is a perception that the government ultimately stands behind these products, the popularity of AMPs have exploded. As lenders compete to match yields, a decent amount of money has gone to fund weaker borrowers and speculative areas such as real estate.

Entrusted Loans

This is the second largest shadow banking source of funds and provides a way for cash rich companies to lend to other firms via banks. However, banks are not only acting as middlemen but have also been using the product to make loans themselves. Due to light regulation, many of these loans have gone to risky borrowers.

Interbank Funding

This actually isn't a direct source of shadow banking funding but rather used by banks to inflate their balance sheets in order to sidestep regulatory limits on lending and adds to the risky interdependence of the Chinese financial system.

Structured Deposits

These products offer an enhanced yield that could be reduced to a low yield should an event (usually an unlikely if not impossible one) happens within a set time frame. By doing this, financial institutions are able to bypass laws barring return guarantees to investors.

All of this is important because defaults in China have been rising and have the potential to worsen. Total missed payments in 2019 exceeded 130 billion yuan, more than 4 times the level in 2017. With Moody's Investors Services expecting ~50 first time defaulters this year (vs 36 in 2019), the overall health of the Chinese financial system will be a key theme in 2020.

FORECASTS

EUR

The EUR seemed to be building a foundation along with some upward momentum toward the end of December but that has been temporarily derailed once again. Weak German economic data and safe haven demand due to increased Middle East tensions have caused the EUR to correct lower. Investors and traders remain optimistic as the reduction in trade and Brexit risks pave the way for an improved economic outlook. Expect more sideways trading in the short term but look for the EUR to remain supported.

GBP

The GBP had a spectacular resurgence since September 3rd, appreciating nearly 8.3% against the U.S. dollar as optimism spreads regarding a successful conclusion to Brexit. However, the GBP has been trading sideways and consolidating since mid-December as the markets evaluate the heavy lifting that still remains to strike a trade deal with the EU over the months ahead. Expect further consolidation in the near term but look for the GBP to remain supported.

JPY

The JPY has been on a weakening trend since September 1 resulting in a 2% weakening against the U.S. dollar that coincided with the resumption of U.S. – China trade talks. Over the past month, the yen has consolidated but most recently the JPY has been the top major performing currency (up in six of the seven past sessions). U.S. short term interest rates have faltered once again and markets have gone into a short term risk-off mode provoked by new Middle East tensions. Continue to expect the JPY to correlate strongly with U.S. interest rates and any changes in geopolitical risks.

CAD

The Canadian dollar continues to be one of the top performing major currencies over the past month right after the NOK. Rising energy and commodity prices have played a key role in this change in sentiment toward the CAD over the past month. In addition, Canadian 2-year interest rates (1.63%) remain above U.S. 2-year interest rates (1.52%) and have added to the positive shift in investor sentiment. In the short term, the CAD appears to be consolidating its most recent gains; expect more of the same next week with a key focus on the U.S. and Canadian jobs reports on Friday.

CNY

The CNY has continued to advance since December, buoyed by the successful conclusion to the trade deal with the U.S. and economic signs indicating that the Chinese economy is beginning to stabilize. This past week, the Chinese central bank injected more liquidity into the system adding to the expectations of a continuing proactive approach by the government to re-energize the economy. Over the past week, the CNY has remained below the key psychological level of 7.00/$ and is approaching its best levels since August. Expect consolidation ahead this week until the U.S. jobs report.

AUD

The Aussie mirrors much of the recent developments of other key major and commodity linked currencies piggybacking the positive run-up in commodity and energy prices in December. In addition, the AUD has been supported by the successful conclusion to the Phase 1 trade agreement. Markets remain biased toward another RBA rate cut in February but that probability has dropped significantly from near 70% a month ago. Expect a steady and range bound AUD this week.

MAJOR CENTRAL BANK ACTIVITY THIS WEEK

1/8 Poland Expectations for rates to be unchanged at 1.50%
1/9 Israel Expectations for rates to be unchanged at 0.25%

KEY MARKET MOVING ECONOMIC RELEASES

United States and Canada

1/7 Trade Balance Expectations for a much lower trade deficit at $44.5 b
1/7 Factory Orders Expectations for a decline of 0.6% after a 0.3% gain
1/8 ADP Employ. Report Expectations for a gain of 163k following a 67k print
1/10 Jobs Report Expectations for a gain of 166k; UR remains at 3.5%
1/7 Canada Trade Report Expectations for a near unchanged deficit of C$ 1.0 b
1/10 Canadian Jobs Report Expectations for a gain of 32k after a -71.2k print

Europe/Eurozone 

1/9 EZ UR Report Expectations for an unchanged UR at 7.5%
1/7 German Factory Ords. Expectations for a gain of 0.2% following a -0.4% print
1/8 German Indust. Prod. Expectations for a gain of 0.8% after a -1.7% print

Asia/Japan, and New Zealand 

1/8 Aussie Trade Balance Expectations for a smaller trade surplus at A$4,100m
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