Morning Commentary: Currency Beast from the East

Foreign Exchange - Morning Commentary
Currency Beast from the East
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The Chinese yuan has strengthened by ~4.5% since the end of June, putting it on track for it’s biggest quarterly gain since at least 1981 when Bloomberg started keeping track of the currency.  Certainly, US dollar weakness has been a contributing factor, but the Chinese side of the USDCNY currency pair has also played a significant role.  

Specifically, a strong balance of payment position forms the foundation for further CNY strength.  China’s export sector gains have stayed resilient over recent months and has started to show signs of broadening out beyond medical equipment.  The recent bounce in capex activity should bode well for China in the coming months.  

The two main drivers behind the growth of China’s current account surplus—a drop in oil imports and a narrowing of China’s services deficit due to a pullback in outbound tourism—should persist for the foreseeable future.  Crude oil prices have fallen ~40% from where it was at the beginning of the year.  Should it stay around current levels, this could add an additional ~$50 billion to China’s current account surplus.  Additionally, the flare up in COVID-19 cases around the world should keep global travel subdued.  Per some estimates, travel is unlikely to return to pre-COVID level until 2024.  

Further supporting China’ balance of payment position has been bond inflows.  The US-China interest rate differentials currently sit near their all-time highs.  This should continue to attract inflows as market participants search for yield in a global “lower for longer” environment.  On a YTD basis, flows into Chinese bonds has totaled ~$88 billion which puts the monthly rate at roughly double what it was in 2019.  Should China win inclusion into another major bond index review in the coming weeks, this would lead to even more inflows.  

Regarding the exchange rate, daily currency fixings show China’s central bank exhibiting little signs of resisting currency appreciation as the fixing error term remains largely neutral.  This marks a shift from when Chinese officials worried about a strong yuan hurting the country’s exports and could be reflective of China’s “dual loop” development model that emphasizes domestic consumption.  With Chinese President Xi Jinping pushing for a more self-reliant economy, the bias becomes for less official currency resistance in the absence of overt CNY overvaluation.
  • The Fed held rates steady as expected with Chair Powell emphasizing that they are not out of policy tools.  The central bank also updated its forward guidance to reflect its new inflation framework as expected.  It now expects to keep rates in the zero to 0.25% range “until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time."  
  • President Trump has weighed in on the proposed stimulus plan that came from a bipartisan group of 50 lawmakers by calling for a package with “much higher numbers.”  It’s unclear what number Trump is looking for, but per Republican Whip Thune, there is a threshold number that can garner Senate Republican votes so the package has to “…stay in sort of a realistic range.” 
  • The Bank of England kept its policy rate and its bond purchase target unchanged by a 9-0 vote.  Notably, the bank surprised markets by announcing it is studying how negative rates might be implemented.  The GBP dropped sharply on this revelation.  The UK is facing a relatively slower COVID-19 recovery, sizable fiscal cliff and rising hard Brexit risks.  These factors make the BoE one of the most likely banks to go to negative rates. 
  • PM Johnson granted a concession to Troy rebels on the Internal Market Bill.  There will now be a parliamentary vote if measures of the bill break international law.  This could be a strategic concession as the PM may be realizing he has overplayed his hand with the EU.  In the US, presidential candidate Biden criticized Johnson’s bill as it risks peace in Northern Ireland and indicated that a US-UK trade deal wouldn’t be possible if the Internal Market Bill becomes law. 
  • The Bank of Japan held rates unchanged as expected but upgraded its economic assessment.  
  • Australia delivered a strong jobs report with the economy adding 111K jobs against consensus for a loss of -35K jobs.  The unemployment rate also dropped to 6.8% from 7.5%, significantly beating estimates.  This reading is particularly positive as it comes after the lockdown in Victoria.  The one note is that jobs gains are heavily skewed to part-time positions (74.8k) instead of full time (36.2k) jobs.
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