The markets continue to be a mine field for doubters of the Trumpflation rally. Although the rate of ascent has slowed, the bears who think the rise has been “too far too fast” are as frustrated as a group of seventeen year old boys playing Dungeons and Dragons in their parent’s basement on a Friday night.
There are some signs the rally is due for a pause, but so far anyone who has preached caution has quickly looked like a chump as prices grind relentlessly higher.
One of the more peculiar aspects of this rally has been the fact some of the market worries which previously caused so much angst, are now being ignored. The Chinese Yuan is the perfect example.
The Chinese Yuan has been declining since the surprise devaluation in the summer of 2015.
During this period the CNY rate has fallen from 6.20 all the way to 6.91 (a rise in the CNY rate means the Yuan is weaker). This 11% decline caused all sorts of headaches for US risk assets during the first half of the move.
Periods of Yuan weakness were met with considerable fear. This article from January 2016 demonstrates the angst felt at that time about the problems associated with the weaker Yuan.
And in fact, the implied volatility of the CNY rate used to track US stocks quite closely. This chart of the inverted USDCNY 6 month at the money implied volatility option rate previously traded right on top of the S&P 500.
When investors pushed up CNY vol, they pushed down the S&P. When the opposite happened and less premium was demanded to hedge CNY, stocks rose.
During the last two weeks CNY vol has spiked while stocks have also rallied.
What’s going on? Why the change?
During the summer of 2015 when the People’s Bank of China initially surprised the market with the overnight devaluation from 6.20 to 6.40, the market became fearful more devaluations would be needed. US stocks responded by plummeting lower in quiet illiquid summer conditions. This was the period when many prominent hedge fund managers got on TV and talked about the need for the CNY to move to 8 or 9.
Every little move in the CNY rate suddenly became the start of something bigger. Rises in CNY were often preludes to US stock market corrections.
Over the past six months the CNY has continued to weaken, but it has not caused any corresponding pain in the stock market.
I think this is because the CNY is no longer weak on a global basis. The PBoC has swapped the dirty US dollar peg with a managed currency tied to a basket of global currencies.
Although the past six months has seen plenty of Yuan weakness against the US dollar, against most other currencies, the Chinese currency has been stable. The Yuan actually stopped weakening at the end of the summer.
USDCNY is rising, but no faster than the US dollar is rising against most other currencies.
Yet is this CNY weakness against the US dollar truly benign?
Have a look at this chart of the US 10 year yield versus the USDCNY rate:
They are trading in an eerily similar lockstep.
I am not smart enough to know which is leading, but there is no doubt all these moving parts are connected together in a complex web so intricate that few understand all the subtle interactions amongst various markets.
Is the recent CNY weakness one of those situations of “it doesn’t matter until it matters?” Will we look back and wonder why we didn’t see the clues lying right in front of us? Or does the fact the CNY is now tracking a basket of currencies mean we should ignore Yuan weakness as merely an offshoot of US dollar strength?
I am not sure. I find it ironic how a year ago everyone was freaking out with a move from USDCNY 6.20 to 6.40, but today we have a rally from 6.62 to 6.92, and yet the stock market is hitting new highs.
There can be no doubt the Yuan depreciation has forced Chinese investors into alternative stores of value. Have a look at this chart of the Yuan versus the LME primary metals index.
Is this “Trump infrastructure” industrial metals rally really just a Chinese devaluation play?
Right now we are in the midst of a mad scramble out of “deflation forever” assets into the “second coming of Reagan” growth vehicles. As this monster shift takes place, it is not wise to place too much weight on various asset’s short term price moves. There is a lot of volatility associated with the rebalancing.
Let’s see how everything settles next week. In the mean time, keep your eyes on the CNY rate. Most especially watch for a situation where the CNY declines, not just against the US dollar, but against other currencies. It has been a while since the market has been concerned about the near term price of the Chinese Yuan, but I am not sure how long that will last.
Thanks for reading and have a great week-end,