The Peoples Bank of China (PBOC) has devalued the Chinese Yuan three times in as many days and the US dollar has been at the mercy of it. This will likely have an effect on inflation and the market sees a lower chance of a September rate hike as a result. Is there any hope for the dollar?
The PBOC took the market by surprise at the beginning of the week when it devalued the Yuan by the most in 20 years; 1.86% to be precise. Since then the reference rate has been moved a further two more times, by 1.6% and 1.1% respectively, so that it went from 6.1162 all the way to its current 6.4010. The effect on the US dollar index was strong, sending it tumbling as investors sought out the euro, the Swiss franc and the yen instead.
The move from the PBOC is understandable. The economic troubles in China are becoming apparent with the turmoil on the Shanghai stock market merely a symptom. Industrial production figures were released yesterday and fell from 6.8% to 6.0% y/y. Earlier this week, Chinese PPI dropped a staggering -5.4% y/y and last week the trade balance painted a bleak picture. The capital outflows from China are also a concern and something the PBOC will be keen to halt and a devalued yuan will help.
The PBOC is moving to shore up China’s export sector and take the pressure off the pegged currency, which would have seen serious pressure in the face of a rate hike from the Fed. There is another reason for the devaluations, namely the IMF. China wants the Yuan to be a reserve currency and be included in the IMF’s basket of “special drawing rights” (SDR) reserve currencies. Such a controlled currency is unlikely to be accepted as a reserve currency by the IMF and the financial industry, so the PBOC is reforming their yuan policy. Exact details of those reforms remain to be seen.
The market fears that a weaker yuan will have a dramatic effect on US inflation because the US imports so much from China, and those imports will now be cheaper. Subsequently the market has cut its expected probability of a rate hike in September from 54% a week ago to around 40% currently. The Fed is not likely to be amused by the devaluation and will be faced with some headaches going forward, none more so that the dilemma on whether to hike rates or not.
The US dollar took a sharp dive against all of its major trading partners, bar the Yuan, thanks to the expectation of US rate hikes. The US Dollar index broke out of the rising wedge it was forming, and went from 97.200 to as low as 95.920 before recovering somewhat. Against the Euro, it gave up 170 pips at one stage, touching 1.1213 before dipping back below the 1.1200 mark. The US Dollar lost as much as 2.07% against the Swiss Franc before closing down 1.14% as investors sought safety.
Is there any hope for the USD now? Looking back at Atlanta Fed chief Dennis Lockhart’s words earlier this week, he suggested the Fed was ‘close’ to raising interest rates in September. He also said subsequent rate rises would depend on inflation, which suggests the Fed will push ahead with September regardless and then look at the data. So we may see one rate rise this year and one only, but it remains to be seen.
The PBOC’s triple surprise devaluation of the Yuan comes not without reason, but its effect on the US dollar was enormous and unexpected. The market is pricing in a lower probability of a rate rise, but this may happen regardless.