Past few days have seen China devalue Renminbi by about 2% that caused quite some excitement in the markets. The depreciation is seen by some participants as a symptom of slowdown in Chinese economy especially in exports which comes as a strong reminder on the importance of maintaining robust domestic demand. Basing long-term growth model on exports alone means the economy becomes dependent on global growth. Devaluation and subsequent depreciation that followed the PBOC announcement had a wider effect on the currency market through safe haven flows. Swiss Franc and Japanese yen strengthened as emerging market currencies weakened. Speculation on the devaluation impacting on FOMC rate setting as well resulted in weakening of the US dollars across the board (yet to quite fully understand some of the exaggerated moves, seems to have been a combination of panic, short-covering and misconceptions behind China’s move).
US & UK markets
Its a bit surprising US dollar and British pound are still in consolidation with tightening cycles just a few weeks away(If Central Bank comments are anything to go by, likely the case). Market participants generally expect the US Fed to hike rates before year end and for the Bank of England to follow immediately after. Although currency appreciation in both instances may complicate situation, both central banks may have to accept stronger currencies since at the moment economic conditions do no warrant extra-ordinary measures. Holding interest rates at ZLB carries significant risks on the economy since the market might become too accustomed to low interest rates and accumulate too much risks. Goldman Sachs have been calling for a buy in US dollar anticipating a 20% rally in the currency.
Chinese currency devaluation of 2% shouldn’t be a concern in my view, US still has an inflation differential advantage of about 1.5%(prices of goods and services rise faster in China than US, making US more competitive assuming both currencies are unchanged). This means that even though China devalued by 1.9%, the real devaluation was 0.4%. US only starts losing competitiveness once its inflation starts rising to levels at par with China and China continues to depreciate at similar rates.
I am anticipating significant rally in US dollar over coming months.
Inflation in Switzerland has dropped well into the negative territory. In order to counter deflationary spiral risk (Bad cycle where lower prices of goods cause firms profits to fall, falling profits reduce investments by firms, reduced expansion and investment leads to rise in unemployment, rise in unemployment reduces household incomes, reduced household incomes reduce demand for goods and forces firms to reduce prices of goods and the cycle begins all over again, Japan’s story) and support its industries. SNB imposed unprecedented negative rates on deposits balances exceeding specific thresholds taking into account liquidity in the banking system.
Currency market intervention and negative deposit rates in theory are supposed to work in the following way: Increase in liquidity (lots of cash in the market) increases interest burden on deposits(institutions hold more money in form of deposits). Interventions in foreign exchange markets increase liquidity in the banking system making negative interest rates and foreign exchange markets mutually reinforcing. Increase in cost of holding Swiss Franc deposits is supposed to force banks into diversifying into other currencies.
Interest rate differentials between US and Swiss Franc should ideally see USDCHF rally to parity, some significant rally as well in GBPCHF and other Swiss Franc crosses. Should depreciation cycle in the Swiss Franc begin, would expect declining returns from speculative capital investments in Swiss Franc to cause an unwind of present accumulation of capital investment and at some point cause sharper falls. But should the unwind fail to get underway, expect more drastic measures from Swiss Central Bank as it will likely resort to desperate measures in weakening the Swiss Franc in order to support its exports and counter deflationary risks. Direct SNB interventions through EurCHF purchases could mess up the ultimate EurUsd short set up atleast in the short-term but it will be a big risk on SNB’s portfolio to have too much exposure to Euro, it might later begin unwinding when CHF depreciation is on course through Eurusd sales (Selling Euros and replacing with dollars).
Will keep tracking the fundamentals but account for margins on either side due to volatility but would advice either refraining or trading on the trend depending on your assessments of technicals(quite subjective).
Stock are still in bear market alongside the Shilling. The two could as well be mutually reinforcing, falling shilling is creating expectations of higher rates and expected higher rates creating expectations of slower growth in company earnings. It is also possible anticipation of decline in shilling against US dollar after possible rate hike is influencing foreign investor participation. It would be a great time to watch for the attractive counter before the market bottoms out.
[Post will be updated with more information]