The biggest financial shock of 2016 could well be a devaluation of the Chinese Yuan.
The US dollar’s 25 per cent rise on its trade weighted index since March 2014 has been the dominant theme in world financial markets. The “King Dollar” theme has accelerated the 65 per cent fall in crude oil from its 2014 peak and coincided with a 25 year low decline in Chinese GDP growth, wider credit spreads in Wall Street high yield bonds, a $3tn transfer of wealth from the world’s oil producers to its energy consumers and a 1997-98 scale meltdown in emerging markets, led by outright recession in Brazil and Russia.
The Federal Reserve increased its overnight borrowing rate by 25 basis points in its December monetary conclave. However, the Chicago Fed Funds futures markets imply that financial markets volatility and deflation risk will lead to only one, not four, interest rate hikes by the Yellen Fed in 2016. This is the reason the yield on the ten year US Treasury note has fallen to 1.75 per cent and the shares of international money center banks like Citigroup, Deutsche Bank, Bank of America, Barclays, Credit Suisse and Morgan Stanley have fallen 30-40 per cent since last summer, thanks to narrower net interest rate margins, losses on energy lending and high yield debt trading/underwriting.
While the January US jobless rate has fallen to 4.9 per cent and wage inflation has upticked to 2.5 per cent, the financial markets now price in a less aggressive pace of Federal Reserve monetary tightening. This is the reason the US Dollar Index fell almost 4 per cent from its peak near 100 in February 2016. The crash in global stock markets in early 2016 highlights that recession risk haunts the global economy. However, there are no signs of coordinated central bank intervention to bring down the US dollar, a new twenty first century Plaza Accord. On the contrary, the divergence between the Federal Reserve and the monetary policies of the ECB and the Bank of Japan will only widen in 2016. This means it is premature to write the obituary of the King Dollar trend – for now.
It is difficult for the Euro to have a sustained uptrend as long as Dr Draghi promises the financial markets to review and reconsider monetary policy at the March ECB meeting. In essence, the hard money zealots of the Bundesbank and the central bankers of the Governing Council could well reduce the ECB deposit rate to minus 0.4 per cent from the current minus 0.3 per cent. The political risk premium in the Euro could also rise due to the migrant crisis, the weakening of Chancellor Merkel’s stature in German politics, terrorist atrocities, the Brexit risk, the impasse in Spain and the rise of the National Front in France. Even if the Federal Reserve does not raise rates at the March FOMC, the Euro could well fall from its 1.12-1.14 mid-February range to as low as 1.06 this summer. As China’s largest trading partner, the Eurozone faces a fall in trade volumes and capital inflows from the People’s Republic. This will increase deflation risk and cause Mario Draghi to fire his monetary easing bazooka in March.
The Bank of Japan shocked the world in its January 29 meeting when Governor Hirohiko Kuroda unexpectedly imposed a 0.10 per cent negative interest rate on Japanese bank excess reserves. The Bank of Japan’s move was a policy U-turn because Governor Kuroda had earlier denied that he would impose negative interest rates as fiscal stimulus, an epic fall in the yen and the global mania over Abenomics failed to achieve the Japanese central bank’s 2 per cent inflation target.
Risk sell offs in 2016 have led to safe haven flows into the yen, which rose from 120 to 112 against the US dollars. The Bank of Japan’s shock monetary ease coincided with a risk spasm on Wall Street that led to safe haven buying in the Japanese yen. However, negative interest rates in Japan are not bullish for the long term prospects of its currency. I see the Japanese yen depreciating to 125 against the US dollar by year end 2016 as the logic of Abenomics necessitates a fall in the year ahead of Upper House elections the LDP must win under Shinzo Abe.
The biggest financial shock of 2016 could well be a devaluation of the Chinese Yuan. The world’s second largest economy is burdened with $28tn in debt, the biggest credit bubble in human history and the world’s biggest hedge funds have now positioned for a devaluation of the Chinese yuan. China is spending $100bn a month to defend the value of the yuan, the reason Beijing’s state reserves have now fallen to $3.2tn. Chinese state media viciously criticized New York hedge fund billionaire George Soros after he forecasted a Chinese hard landing and yuan devaluation in Davos, Switzerland. Hedge funds have also launched speculative attacks against the Hong Kong dollar peg.
China’s economic hard landing has led to a collapse in the world oil/industrial metal markets, a slump in world trade and a liquidity squeeze in the Hong Kong, Singapore, Sydney and London property markets. China’s casino like stock markets in Shanghai and Shenzhen are down 40 per cent from their spring 2015 peaks. Beijing’s flawed intervention in its financial markets has led to a crisis of investor confidence as offshore funds flee the Middle Kingdom. Chinese corporates face a tsunami of credit downgrades and the state owned Bank of China trades at a mere three times earnings in Hong Kong. Since China has issued an estimated $400bn debt in the international capital markets, a rise in sovereign and corporate credit risk, is a negative omen for the Chinese yuan.
The Communist Party will do its best to restore the world’s faith in its economic policies and stabilize the yuan – but will Beijing’s mandarins succeed in this quest?