The story continues to be
The China of President Xi
Has problems galore
With more still in store
So, traders, as such, want to flee

The issue for markets elsewhere
Is knock-on effects aren’t rare
Protecting the yuan
Means it is foregone
Bond sales will send yields on a tear

For yet another day, China is offering the biggest market stories.  In no particular order we have seen the following overnight; China Evergrande filed for Chapter 15 bankruptcy, a process by which foreign entities can access the US bankruptcy court system, regarding $19 billion of their offshore debt; the PBOC set their CFETS fixing more than 1000 pips lower than market expectations, the largest gap since the process began in 2018, in their effort to arrest the yuan’s consistent decline; and Chinese police visited the homes of the protesters who were complaining about Zhongzhi’s missed payments (I wrote about these Monday in Risks Were Inbred).  And this doesn’t include the fact that Country Garden, the largest property developer in China is losing money quite rapidly and may also be on the brink of bankruptcy.  It seems the Chinese property bubble is deflating.

Ultimately, there appear to be two main impacts of the gathering storm in China, market participants are increasingly leery of taking on risk in general, and the PBOC’s efforts to stem the decline of the yuan means they must sell their holdings of Treasuries to generate the dollars to deliver into the FX market thus adding downward pressure to the bond market.  Of course, one of the typical outcomes of a risk-off attitude is that bond markets rally as investors exit equities and run to bonds.  This stands at odds to the recent bond market behavior, although it is quite evident this morning.  In fact, after touching yields above 4.30% in the 10yr Treasury yesterday, this morning we have seen a half-point rally with yields declining about 5bps in the US.  In Europe, the yield declines have been even greater, mostly around -10bps, so this is a real reprieve for bond markets everywhere.

The key question here is whether we have seen the worst, or if other potential selling catalysts will appear.  Consider for a moment the fact that between China and Japan, they represent >26% of foreign owned US Treasury debt, and that both of these nations are dealing with rapidly weakening currencies.  Not only that, but both have demonstrated they are quite willing to intervene in FX markets to arrest those declines, and as mentioned above, that typically requires selling Treasuries.  It’s a self-reinforcing cycle as higher yields beget currency sales which beget Treasury sales to intervene, which results in higher yields starting the cycle all over.  

With this in mind, we need to consider, what can break the cycle?  Well, if the Fed were to turn dovish and indicate they agreed with the futures markets that rate cuts are coming early next year, I suspect the dollar would fall against most currencies, especially these two, and the cycle would break.  Alternatively, China could step up and guarantee the debt of Countrywide and Evergrande thus removing the investor risk and reduce pressure dramatically.  Finally, I suppose the Fed could make a deal with the BOJ and PBOC and directly absorb their bond sales, so they never hit the market while restarting QE.  That, too, would likely end the cycle.  It is possible there are other ways to break the cycle, but I doubt we will see any of these occurring anytime soon and so the cycle will have to wear out naturally.  That will occur when either or both of the currencies decline far enough so the market believes the trade has ended and unwinds their short positions.  In other words, none of this has changed my view that 7.50 is on the cards for USDCNY as the year progresses, very possibly with 10yr yields getting to 4.5% or more.  And don’t be surprised if we see another move to 150.00 in USDJPY.

But, away from the China connection, things are very much in the summer doldrums.  Equity markets have been treading fearfully and continue to do so this morning.  However, while we have seen several days of declines, there has been no panic selling of note.  So, yesterday’s US weakness was followed by selling throughout Asia and this morning in Europe with most markets down about -1.0%.  US futures, too, are softer, down about -0.5% at this hour (8:00).

Oil prices (-0.85%) which stabilized yesterday, are back under a bit of pressure on the overall negative risk sentiment as they continue to trade either side of $80/bbl.  Metals prices, meanwhile, are mixed with precious metals finding a bit of support while base metals suffer today.  The most interesting story here I saw today was that CODELCO, the world’s largest copper miner in Chile, may be going bankrupt as previous projects didn’t pan out.  That strikes me as a very large potential problem, but one for the future.  

Finally, the dollar is mixed this morning.  It had been softer overall in the overnight session, but as risk is getting marked down, the dollar is gaining strength.  The biggest mover has been PHP (+1.1%) which rallied after the central bank indicated they were going to put a floor under the currency and adjust rates accordingly.  After that, the EMG bloc has not done very much, +/- 0.25% type activity.  However, just recently, G10 currencies started to slide with NOK (-0.8%) the laggard as oil slides, but the entire bloc now coming under pressure.  This is all about risk off.  

There is no US data today nor are there any Fed speakers.  As such, the dollar will take its cues from the equity markets, and the bond market to some extent.  Right now, equity weakness is driving the risk attitude and that means the dollar is likely to remain bid into the weekend.  Next week brings the Fed’s Jackson Hole meeting where everybody will be looking for any policy hints by Chairman Powell on Friday morning.  But for now, the dollar is on top of the mountain.

Good luck and good weekend

Adf