Monthly Brief July 2019 – Chinese Yuan

Monthly Brief July 2019 – Chinese Yuan

CAPITAL MARKETS

With recent developments during the first days of August, we are updating this writing as of August 5, 2019.

For some time now, global capital markets have appeared to trade more often based on the news-flow regarding both trade wars and lackluster global economic predictions than on actual data.  And as these issues became more commonplace it appeared as though their shock value had been wearing off.  Whether due to the increased familiarity causing these topics to lose their punch, or the Federal Reserve’s implicit message that they will act (at least in part) to stabilize capital markets, investors had moved most equity market gauges back to new highs.

But in recent days, some important developments have occurred to challenge the notion that the threats emanating from these issues are benign.  On July 31, the Federal Reserve cut the Fed Funds rate by 0.25% and many would have expected this acknowledgement of having raised rates too quickly to have provided support for equity markets.  Rather, markets declined as the S&P 500 Index dropped over one percent.  Could this be signaling that investors believe equity markets are more supported by Fed stimulus rather than economic and corporate conditions? If so, can/will the Fed continue to oblige?

And now, a new chapter of the trade wars has begun – currency devaluation.  By intervening in the value of their currency, China has embarked on a tactic to ease the sting of tariffs, without needing an agreement with the US.  By devaluing the Chinese yuan, the cost for goods in US dollars goes down.  (For example, if China was to devalue its currency from 6 yuan per US dollar to 7 yuan per US dollar, each dollar can now buy more goods denominated in yuan, thereby absorbing a price increase such as that created by a tariff.)  Of course, this also works the other way where US goods become more expensive when purchased in yuan.  Additionally, overshadowed by the currency news, were reports that China has also asked state-owned entities to suspend buying of US agriculture products.  Should this be fully acted upon, it provides further concern for an important part of the US economy. 

For some time, investors have acted as though deterioration in US-China relations is an inconvenience that can be worked around. This new action appears to have reawakened global investors to just how large the stakes truly are in this stalemate. China’s most recent actions reminds us that a state-influenced (controlled?) economy may choose strategies different than to that which US investors are accustomed.

CHART OF INTEREST – CHINESE YUAN

With currencies being globally traded, how can one country choose to “set” the value of its currency?  For China, state intervention in capital markets is not new. While the free-floating currency would be expected to move based upon the “market’s” activity, sovereign entities can intervene for various reasons.  Often, we hear of intervention to stabilize a currency, such as that which has occurred often in history in Latin America.  However, although somewhat rare, this intervention can also take the form of adjusting a currency for other reasons.  In this case, China has chosen to use its currency as a tool in the current trade dispute with the US.

On August 5th, China conducted market actions to devalue the yuan. Having moved it to the desired level, outside currency investors responded by further moving the yuan/dollar value during the day.  On the chart of this action, the yuan’s value can be seen to have been relatively stable through the end of July, then moving modestly on August 1st and 2nd, followed by China’s actions on August 5th. Following the intervention, trading in the open market weakened the yuan even further. 

Going forward, the level of 7 yuan/dollar will likely be an important gauge as to China’s potential future intentions.  Should it move back toward, or below this level it will appear that this initial intervention was a warning.  Should it stabilize or move further above this level, it may be signaling a new level of determination by China in the trade dispute with the US.

James Ferrin, CFA
Chief Investment Officer

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