10 August 2018
A weaker Chinese Yuan: Contagion or confusion for global currencies?

While weakness in the Chinese yuan (CNY) is being touted as a source of global market risk, we find limited evidence of broad-based contagion from independent CNY weakness – with the spillover effects varying across regions and specific currencies. Our view for a more stable CNY could see Asia FX tactically outperform the more vulnerable CEEMEA FX space

Key messages: Limited signs of broad-based contagion from a weaker CNY

  • While in the currency space, the Chinese yuan (CNY) has been one of the biggest direct casualties of President Trump’s rampant trade war, we attempt to unravel the extent to which CNY weakness has been a source of risk for global FX markets.
  • We find limited evidence of broad-based contagion from independent (non-USD-related) CNY moves in the current trade war episode – with the spillover effects varying across regions and specific currencies. We also note that the spillover effects vary over time depending on the prevailing PBoC FX policy regime.
  • Regional disparities show that Asian FX suffered the most collateral damage from a weaker CNY as the US-China trade war has escalated, with the cross-correlations between other EM FX blocs (Latam and CEEMEA) and the yuan significantly lower.
  • We expect the removal of CNY weakness as a source of market risk to remove the depreciation bias in highly correlated currencies – and allow for both a relative relief rally and local factors to dictate currency movements. While under benign conditions, Asian currencies would have probably seen a sharper relief rally under a more relatively stable CNY, the current market turmoil in EM FX – namely Turkey and Russia – is likely to counteract any broad move lower in USD/Asia FX.
  • We think a more stable CNY could allow for a relative outperformance of Asia FX versus CEEMEA FX – with the latter group of currencies playing catch-up to the more oversold Asian currency bloc. More specifically, we also see some spillovers from the fragile risk environment (TRY collapsing, USD/CNY higher, EUR/USD below 1.1500) into the CEE FX – with HUF underperforming the CEE region.
  • With EMEA a source of geopolitical risk, we think it will be difficult for the ZAR to also stabilise – in effect the Rand's source of market risk has shifted from a weaker CNY to a weaker TRY and RUB.
Turkey flash crash: Chaotic contagion

A sharp drop in the Turkish lira could have implications for Europe's banks and the Federal Reserve's interest rate path. We expect the yen to remain a preferred safe-haven vehicle

USD: Hard to talk economics amid geopolitical turmoil

While we think the short-term cyclical US dollar dynamics may have peaked – with today’s US CPI data likely to corroborate this view – it is difficult to credibly pitch any short-term economic view when global FX markets are grappling with a significant degree of geopolitical angst and unprecedented wild swings. In this environment, the mindset will remain ‘default to dollars’ – not least when the Fed is seemingly the only central bank tightening in any sustained manner. Were these emerging market gyrations to continue, however, one could imagine that the Fed may have to consider a pause in its tightening cycle – a stance we saw adopted in 2016 (Chinese yuan weakness and Brexit). From a data standpoint, the focus will be on July US CPI today; it’s interesting to see US Treasury yields holding up fairly well despite the market turmoil that we are seeing in the emerging markets world. This may not last if things were to get worse – and if there is no major upside surprise in US CPI inflation, investors could start to rethink a more hawkish Fed. Still, look for the dollar index to move higher towards 96 as risk-off prevails.

US yield curve: Self-fulfilling prophecy?

Like everyone else, the Fed is watching the yield curve for signs of the next recession. But it seems unsure on what signal to take from the flattening curve

The yield curve tells us about recession risk

The US economic expansion is now into its ninth year, the second-longest on record. So even as growth is hitting new heights, it’s little wonder there is more and more anxiety about when the next recession might come along. In particular, the US yield curve has been under increasing scrutiny. When short-term rates rise above long-term rates and the curve inverts - a recession usually follows. This is why the inverted yield curve is one of the most widely followed early warning indicators.

The yield curve’s predictive power is generally believed to be derived from the way the curve captures investor’s beliefs about the outlook for the economy. When the economy is expected to do poorly, investors prefer to lock in safe returns, which pushes long-term yields down relative to short-term yields, causing the curve to flatten and eventually invert.  

If the Fed sees inversion as a reliable precursor of weaker growth, especially if it coincides with other signs of slowing growth, then an inverted curve could lead to slower hikes, or even a pause

But there is also an element of self-fulfilling prophecy going on here. If near-term yields are close to or higher than long-term ones, then banks and investors are incentivised to keep cash in relatively high-yielding short-term bonds rather than lend or invest in new projects which hampers economic growth in the near term. To the extent that markets take a flattening or inverted yield curve as a sign of trouble ahead, risk-aversion reinforces the adverse effect on the economy.

Russia: Hit by a double shot of sanctions

Russian assets have sold off heavily over the last 24 hours on the back of two US sanctions stories. The mood in the US Congress towards Russia certainly seems more aggressive and less predictable. Ahead of US mid-term elections in November, we expect a greater risk premium to be demanded of Russian asset markets

What’s the news on sanctions?

The first is the leak of the contents of a draft bill - the Defending American Security from Kremlin Aggression Act of 2018 (DESKAA) – which currently sits in the US Senate. The contents were roughly known, but the leak in the Russian Kommersant Daily provided the full text of the bill including naming eight Russian financial institutions with whom US persons would be prohibited from trading.

The leak also highlighted the threat that would prohibit US participation in new Russian sovereign debt issuance. Since Russia’s annexation of Crimea in 2014, a series of US sanctions have so far avoided targeting Russian sovereign bonds, OFZs, largely because of the potential impact on US funds invested in Russia.  Were the DESKAA bill to progress, it would certainly open a new chapter in the financial sanctions against Russia.

The second piece of news was the imposition of sanctions, largely on Russia’s ability to buy US national security sensitive goods and technology. This followed the US State Department’s finding that the Russian government had been involved in the use of chemical weapons in the Skripal attack in the UK. These sanctions can be extended if Russia does not deliver a commitment against the use of chemical weapons or does not allow UN inspectors into Russia – neither of which seems likely.

Four charts show the risk of a ‘no deal’ Brexit to the UK economy

Talk of a 'no deal' Brexit is ramping up as UK lawmakers remain divided on future European trade. We still think it's more likely that an agreement will be struck to prevent the UK from crashing out of Europe without a deal, but if we're wrong, here are a few key ways the economy could be hit 

There are 233 days to go until Brexit and with negotiations stuck in deadlock, talk of 'no deal' is ramping up. The number of news stories discussing the topic has spiked, while Google searches for 'no deal Brexit' have surged. This comes as the UK government prepares to outline its contingency preparations for a possible hard exit next March, something which International Trade Secretary Liam Fox suggested over the weekend now has a 60% probability of occurring.

At this stage, we still think it's more likely that the UK and EU forge an agreement to avoid the hardest of Brexit scenarios, allowing the transition period to begin after March 2019. But the situation is highly uncertain and if we're wrong, the economic impact could be significant. Leaked UK government forecasts earlier this year suggested that without a deal, the economy could be 8% smaller over a 15-year horizon relative to current projections.

There are many potential ways the economy could be hit if 'no deal' happens, but here we take a look at a few of the major factors at play.

US yield curve and recession risk - watch the shape not the slope

With the 2s10s yield curve on a persistent flattening trend and dipping below 25bp last month, talk about a possible downturn in 2H19/2020 has heated up. We don't think the US curve will invert anytime soon but when it does in 2019 keep an eye on 2s5s10s - the alternative bond market recession indicator

As we expect US 10-year Treasury yields to break back above 3% later this year, the 2s10s curve shouldn't invert anytime soon. When the curve does invert, possibly around mid-2019, a recession may not necessarily be around the corner, as the curve circumstances seem to resemble 2005/2006, when the term premium embedded in longer-dated yields was also very low. However, the message from a flat/inverted curve shouldn't be ignored, as it could hurt banks and the process of credit creation, potentially making an economic downturn self-fulfilling. 

Ironically, if the Federal Reserve were to take it seriously and become reluctant to hike rates further – unlike in 1H06 when they hiked rates a further four times – it might reduce the likelihood of a near-term recession, as monetary policy probably wouldn’t turn really restrictive. We closely watch the 2s5s10s (butterfly) valuations and Leading Economic Index to asses when a recession becomes truly imminent.

Reading time around 9 minutes

In case you missed it: Emerging markets in turmoil

A flash crash in the Turkish lira, a double shot of sanctions on Russia and weakness in the Chinese yuan sent ripples through global markets this week, sparking concern that Europe and the US could be drawn in, just as Brexit risks mount and the US yield curve flattens out. Can the strain be contained or should we worry about contagion?   

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