The Shanghai Composite closed down 3.72% today as Chinese investors returned from their Golden Week holiday to play catch up vs. their emerging markets brethren. Last week, the rise in the dollar caused bonds to sell off on the back of better U.S. economic data -- causing yields on the U.S. 10-year to rally up to 3.2%. During Golden Week, offshore yuan traded past the psychological 6.90 yuan vs. the dollar highs witnessed over the summer. There was reason to lean over the yuan, given the slowing manufacturing data reported last week, which was lowest in 16 months.
Over the weekend, the PBOC did by 100 bps (a full 1%!). This move will release about 1.2 trillion yuan (~ $174 billion) worth of liquidity into the system. This is a supportive mechanism aimed to boost asset prices to offset trade war and slowdown fears. From a pure textbook economic perspective, given the U.S. Fed is on target to raise rates four times this year and with PBOC embarking on a loosening path, it is no wonder that the yuan needs to fall vs. the dollar. However, as experience has taught us, Beijing will let the yuan fall as and when it suits them. It pays never to bet against the Chinese central bank. Beijing still has about $3 trillion in FX reserves, some are wondering if that is enough?
Chinese credit impulse data will start to show improvements soon, given their announcements on boosting liquidity and infrastructure investments. Also, as obvious as it may be to short the yuan, it is a rather expensive trade -- as seen by the one-month offshore yuan implied yield. Those betting against China can wake up one morning with the slightest announcement catching them short.
Quite a few shocks appeared in the markets over last few days. U.S. 10-year bond yields rallied dramatically last week. It was not the level of the yield that worried investors most, it was the rate at which the yield rose. Equities and risk assets, in general, can withstand a higher yield environment if it is a result of better economic data and positive risk environment. If the rate of change of yield is swift at a time when the market is worried about a slowdown, then equities get jittery. That is what we witnessed last week when markets sold off aggressively towards the end of the week.
It seems the market is waiting to take its cue from the currency markets -- the dollar. As mentioned earlier, the fate of all risk assets is tied to the path of the U.S. dollar. Sub sectors have been oscillating back and forth, cyclicals outperforming defensives at times of "risk-on" and vice versa during "risk-off" mode.
It is hard to know which way it can go, but one can only take a firm view and belief in the fundamental stories and valuation metrics. Waiting for the market to give us any clues will be hard. Do your homework, know your levels -- and when the markets, or individual assets, reach those levels -- participate. If you wait to buy when market is up, or sell when market is down, you will end up being whipsawed.
If the dollar rallies substantially from here, emerging markets will take another leg lower, along with commodities and risk assets. If it stabilizes and the yuan no longer falls, then slowly select commodities and their respective stocks can close the valuation gap.
Oil, which is moving on a negative correlation to the dollar, is now looking extremely tired as Brent touched $85/bbl. With prospects of oil being priced at highs in local currency terms in select emerging markets, there is no doubt that demand will be softer going forward. All this at a time when supply is rising. The risk-reward equation does not bode well for oil. If we are truly worried about a slowdown, then why should oil be left unscathed?