President Trump upped the ante in the trade war with China last week by increasing the tariffs on Chinese goods. Over the weekend, China retaliated by devaluing its currency. The People's Bank of China explained the drop in the yuan as "due to the effects of unilateralist and trade-protectionist measures and the expectations for tariffs against China."
Market players had been anticipating some form of retaliation, but were looking for an increase in tariffs or less buying of agricultural goods. The currency move is a much more aggressive response and has a ripple effect on other economies around the world.
The weaker yuan makes Chinese goods relatively cheaper and offsets some of the impact of tariffs, but it makes the currency less attractive and creates conditions for it to continue to move lower as investors look to preserve buying power. An outflow of capital from China offsets the benefits of lower prices for its goods.
This move is reverberating around the world with equities selling off, the yen attracting safe-haven buyers and gold jumping higher.
This move comes at a difficult time technically for the indices, as they have been under pressure and just suffered their worst week of the year. Market players were hoping that things were oversold enough for some bounce, but with the sharply lower open this morning there is likely to be more technical selling as well as a little panic.
The market has been sanguine about the trade issue for a long time as there has been confidence that the dovish Fed would provide support and prevent any major drawdowns. That shifted last week when Fed Chairman Jerome Powell indicated that the Fed was not launching a major campaign to cut rates.
Market players will be watching now for some indication from Fed members that there will be more-aggressive cutting to combat the fallout of the China devaluation. That is the most likely event to bounce the market in the near term.
Investors have grown used to very fast bounces after a week like the market suffered last week, so they are surprised by the intensity of the selling this morning. We have had some technical warnings that the market was undergoing a change in character, but it still is not too late to raise some cash if support levels are broken.
My game plan is to work on shopping lists but to move slowly and incrementally. There are quite a few small-cap earnings reports coming up, but this action is macro-driven and is not favorable to stock pickers right now.