To me it’s extremely unsatisfying, intellectually anyway, to say something simple like “everything depends on China.” Annoyingly, this is the conclusion I can’t get away from, and neither can the market, apparently. Whether commodities bottom out, whether the US is at real risk of recession over the medium term, whether the Fed will get their hikes done on schedule (or at all), whether High Yield will breach 10%, whether the US Treasury market will correlate positively or negatively with risk assets, and seemingly, whether the S&P 500 will go up or down on any given day, all depend on China. And of course, the economic picture in China is complex and certainly not transparent. To repeat: it’s annoying, but why does everything depend on China, and where to from here?
The Chinese yuan is not a free-floating currency, but rather is tightly controlled by the People’s Bank of China (PBoC). The central bank’s management of the currency has intricate impacts on its foreign reserve balance, and directly on the domestic Chinese monetary policy. Please see Cross Border Capital Flows Part I: a Refresher on the Lingo, Part II: Mind the Sterilizer, and Part III: On the Horns of a Trilemma for more detailed discussion of these dynamics. This week, I’m focused on recent events, and their implication for the future.
Just to rehash quickly where we are: the PBoC devalued the CNY by about 2% back in August, which kicked off the large risk sell-off back at the end of the summer, and then in the past six weeks, they began to migrate their published yuan setting a little weaker each day, telegraphing to the world a trend of moderate weakening. That trend was made clearer when they signaled their intent to manage the renminbi based on a basket of currencies not just the USD. And then came the stock market circuit breakers. Ah, the circuit breakers. With the benefit of hindsight, (and maybe someone could have had the foresight), establishing a 7% limit-down circuit breaker in a volatile falling market was akin to waving a red cloak in front of a bull bear. In essence, this created a run on the Chinese equity market, with those first-in-line to withdraw their money causing two limit-down days before the whole idea of circuit breakers was scrapped. There’s a reason no one announces distressed bank closures in advance. This stuff is bad enough to move global markets fiercely, even though the Chinese stock market is small and technically insulated. Why?
The potential for a vicious circle fueling continued outflows, coupled with the need for genuine onshore stimulus from policymakers who for now appear unable to do so, has caused global markets of all sorts to wobble. Because the policy makers have such a large reserve balance, and are able to combine that firepower with overt or covert capital controls, they may not feel pressure from Impossible Trinity constraints (see Part III). The pressure is going to come from credit destruction, and that probably gets worse, still, from here.
*Something else which annoys the heck out of me, is that we’re still forced to view further Central Bank stimulus as a means to an economic end, now eight years into the post-crisis environment. We can’t seem to get away from it, and each time I hear it, I’m reminded of the “economic original sin” concept I’ve discussed here in the past. We traded a generation of financial repression in exchange for avoiding a depression, and just not enough time has passed for us to move on. See Bob Michele’s Realistic Surprise Number 1 from last week.