Morning Commentary: Ignore the Noise

Foreign Exchange - Morning Commentary
Ignore the Noise
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The Chinese yuan has broken through 6.90 on the interbank market for the first time since January of this year.  Recently, the US and China reaffirmed their commitment to the Phase 1 trade deal despite China being behind the purchase pace needed to reach its targets.  In order to completely meet its purchase goals, China will need to buy roughly $130 billion in goods the second half of this year. 

Outside of purchases, China has also made some progress on other commitments.  This includes modifying regulations on the import of a variety of American farm and food products, removing foreign equity caps on securities and futures, and lowering financial market barriers. 

Nevertheless, tensions between the two countries remain high and should continue to escalate as we move closer to the US elections.  Notably, recent FX price action around the closure of consulates, sanctions on government officials and other US-China action shows that an escalation in US-China tension is not fully priced in.  As such, market consensus remains for these chronic tensions to continue to broaden out and have long term implications but not lead to a breakdown in the Phase 1 deal or fresh tariffs in 2020, a key directional driver for CNY.  This means that headline noise should result in spikes in USDCNY, but the downtrend is likely to continue as these headlines fade. 

Further supporting the yuan are positive cyclical factors.  Trade data continues to surprise to the upside.  China’s position as a leader in the export of COVID-19-related protection goods has helped, but there are also signs of a pickup in consumer demand amid a slow global recovery.  As for capital flows, US-China interest rate differentials sit near all-time highs.  This has drawn record inflows as the global search of yield is heating up.  To this point, international bond inflows have become a meaningful capital account line item in recent years and could see further upside should Chinese bonds gain inclusion in another bond index at the FTSE’s inclusion review in September.  In light of these constructive cyclical factors and persistence around USD headwind factors, CNY’s medium term outlook skews bullish. 
  • The Fed has made a historic change to how it views inflation and how low US unemployment can go.  The Fed will now see to achieve inflation that “averages” 2% over time by allowing inflation to run above the 2% target to compensate for undershoots such as the period we came from.  This means the Fed should be aiming for inflation over 2% for some time.   
  • US initial jobless claims continue to show a labor market under stress as jobless claims topped 1 million claims once again.  Continuing claims declined from last week but still missed estimates as it came in at 14.5 million versus consensus for 14.4 million.   The second release of the US’s Q2 GDP showed a small upward revision to -31.7% QoQ from the initial -32.9% read.  Nevertheless, it remains the steepest decline since the Great Depression.        
  • Hurricane Laura made landfall as a category 4 hurricane but has since weakened to a category 2, which is still the most powerful storm to hit the region since 1856.  Oil prices remain near 5 month highs as investors continue to assess the damage.
  • Capital flow data out of Japan shows that the country continues to be big buyers of foreign bonds.  However, these outflows are likely currency hedged so they have little impact on the yen.
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