Markets Roiled by Yuan Depreciation

The Chinese yuan has depreciated sharply by 2% in the two days after Trump tweeted about additional tariffs. Meanwhile,  markets plunged with US equities clocking their worst day in the year.  The currency has clearly become a primary tool for China’s trade negotiations, just as tariffs are for the US.

Is China Signaling Retaliation?

• After US President Trump threatens additional trade tariffs, China allowed the yuan to depreciate sharply, breaching the key 7.00 level against the USD.

• China appears to be signaling that its exchange rate can be a primary tool of retaliation. This was quickly taken by President Trump as evidence of currency manipulation.

Exchange Rate Depreciation has Virtually Offset All of the Effect of the Tariffs on Chinese Exports

• China’s latest response has been sharper and quicker than usual, promising retaliation and casting doubt whether further negotiations will take place in September.

• Excluding the latest tariffs announced, US tariff collections amount to 12% of China’s exports to the US. Coincidentally or not, the CNY which is more stable and managed than most other emerging market currencies, has fallen 12% since US tariffs have been imposed in 2018 thus far.

• The new 10% tariffs on the rest of Chinese exports would amount to 5% of total Chinese exports to US. Should all of these be offset via the exchange rate, that would imply USDCNH of 7.25. If all of US-China trade is tariffed at 25%, then 7.75 would be the level.

Reminiscent of CNY Weakening in 2015 but Not Quite the Same

• On 11 August 2015, the CNY devalued by 3%, followed by a further 10% depreciation through the end of 2016. The devaluation sparked a global financial panic that lasted over half a year. HK and Chinese equities were most impacted, and USDJPY crashed from 125 to 100.

• Citi analysts feel the broader global economic backdrop is somewhat stronger now than in mid-2015 to early 2016. That period coincided with a severe drop in commodity prices, the Fed entering a tightening cycle, and China’s equity market was unwinding the 2015 bubble.

• Today, political elements of the depreciation are far more concerning than the economic setting. The key question remains, how far are US and Chinese authorities willing to escalate the current dispute?

Citi’s Take: Retain Current Allocation – Central Bank Liquidity Could Help Curb the Spillover

• In the near-term, the CNY is likely to further weaken and global equities may be in for a volatile ride. However, Citi analysts see the Fed and other central banks as poised to ease monetary policy. Such policy support could help cushion the impact of trade conflicts.

• Though equity valuations are falling and high quality bond valuations are rising, Citi analysts feel it may too early to alter their underweight equity and overweight bonds allocation.

• Central bank easing and risk aversion is expected to benefit investment grade USD debt as an asset class. Citi analysts also see somewhat greater opportunities in traditional safe havens like gold.