Wednesday 12 August 2015 by Craig Swanger Opinion

China's woes hit the Australian dollar, oil and equities but boost bonds and gold

The sudden drop in the Chinese currency, the yuan, is a stark reminder to Australian investors that China’s economy is fragile

Chinese stock market

The Chinese central bank, the People's Bank of China, yesterday let the yuan drop 1.9% against the US dollar to levels last seen three years ago, shocking currency markets.

This is the latest move in the currency wars that have been raging between China, Europe and Japan. All three economies have been reducing interest rates and using QE to depreciate their currencies. The lower the currency, the more competitive the country’s exports.

Europe and Japan have got little room left to move having already dropped rates to nil, and with massive QE campaigns.

China on the other hand has reminded the world it has plenty of bullets to fire yet. Not only can they use interest rates to lower their currency, but as the yuan is still managed by the PBoC, i.e. not floating on the free market, they can also change the calculation used to set their currency’s value. And that’s exactly what they did in response to continued weakness in their trade figures. China’s exports in July were 8.3% lower, including a 12.3% fall in exports to the EU.

In a statement yesterday, the Chinese central bank said that it had changed the way it calculated the currency's daily midpoint against the greenback, resulting in an immediate 2% depreciation from 0.1610 to 0.1585, nearly its largest drop ever. Markets are now pricing in the likelihood of more depreciation, judging that if left to free float it would fall far more.

The impacts were significant:

1.   The AUD/USD exchange rate immediately fell 1.1c to 73.02c
Any weak data out of China will cause the AUD/USD to drop. The AUD has become a market trader’s proxy for China GDP. On top of the market traders’ reaction, there is a fundamental rationale too.  A weaker China is bad news for Australia as 6% of our GDP is now driven by our exports to China. Lower GDP outlook will shift the RBA’s bias to lowering rates, which in turn weakens the attractiveness of the AUD. Either way, the AUD will continue to weaken if the outlook for China declines. There will be short term rebounds in the AUD, such as a possible jump today when Australian wage growth comes out, but the medium trend is for the AUD to keep falling into the 65-70c range at least.

2.   US bond rates fell steeply, with both the 5yr, 10yr and 30yr treasury rates falling 9-10bps per annum
The logic behind this is simple. If China devalues its currency, this weakens competitiveness of US exports, which makes an increase in rates riskier for the Fed.  US exports dropped steeply in response to the USD’s sudden climb over the past 12 months, so they won’t want to risk further declines threatening their economic recovery.

3.   US equity markets fell sharply, down 1.5%, as this article was being written
The prospect of a falling yuan against the USD is bad news for US earnings.  As we’ve previously reported, US equities are priced for perfection at the moment, so they are particularly vulnerable to shocks like this.

4.   Oil prices fell sharply on the news, to under $43 a barrel
Because commodities are priced in USD, a lower yuan makes the local cost of commodities higher for commodity importers, lowering demand. Confidence in Chinese economic data is also weak, so when the central bank lowers the currency, it is seen as a sign that they are losing confidence in the economy, also bad for the overall demand for commodities.

5.   Gold prices jump on the lower for longer theme and flight to safety
Gold and bonds are considered the ‘safe harbour asset classes’ as they tend to rise in value when equity markets fall sharply. To a certain extent, that makes gold and bonds ‘competitors’ for the safe harbour investor money. Therefore, when bond yields rise, i.e. when bonds are offering higher and higher income, gold (which pays no income) becomes less attractive and therefore falls in price.

China represents the single largest risk to Australian investors in growth assets such as equities and property. 

Update 13 August 2015

China’s woes continued to hit global markets in the last 24 hours. The AUD fell to a low of 72.40 cents against the USD, before rebounding to nearly 74 cents due to falling US bond yields.  The Dow Jones fell more than 3%, but then recovered almost all of this due to rising oil prices boosting their energy sector.  This erratic performance for equities, the AUD, and oil will continue as markets readjust their expectations of economic growth downwards.  Wall Street has been priced for perfection and so the adjustment could be particularly painful for US equities markets, but as always spill over to other global markets.

Bond markets in the US went through similarly wide ranges with the 10 year Treasury bond yield falling from 2.14% to 2.04% at one point, before rebounding back to 2.14% again. 

In Australia, wage growth remained very low at 2.3%p.a., the lowest reading on record for the 2nd quarter in a row.  This news will keep the RBA’s bias toward reducing rates.  Australian bond yields fell reflecting this forecast, with 10 year yields falling around 11bps.  While the AUD fell steeply during the Australian day, it jumped more than 1c overnight.  This appears to be a response to lower US bond yields, rather than specifically about the AUD’s prospects, and therefore represents an opportunity for anyone looking to take a long term, short position in the AUD (an Australian investor buying USD is effectively selling AUD, hence they are “short AUD".)

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