Asia | China | FX | Monetary Policy & Inflation | Rates
My discussions with macro investors have recently centred around two questions. First, could the RMB extend its gains further? And second, could the worsening floods and issuance pressure lead to weakness in the bond market?
Stay Bullish RMB, Monetize High Vol.
In my last update on 5 June, I made a bullish case for RMB. I argued that, despite the lingering risks of trade tensions, RMB would benefit from policy divergence, USD weakness and US elections. Since then, USDCNY has fallen to 6.90. I expect this trend will continue over the next 3-6 months, though some consolidation is due around current levels.
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My discussions with macro investors have recently centred around two questions. First, could the RMB extend its gains further? And second, could the worsening floods and issuance pressure lead to weakness in the bond market?
Stay Bullish RMB, Monetize High Vol.
In my last update on 5 June, I made a bullish case for RMB. I argued that, despite the lingering risks of trade tensions, RMB would benefit from policy divergence, USD weakness and US elections. Since then, USDCNY has fallen to 6.90. I expect this trend will continue over the next 3-6 months, though some consolidation is due around current levels.
While USD bearish trades have become fairly consensus, I am comfortable maintaining short USDCNH cash positions as a core view. The aforementioned rationale is still valid. And, while the RMB has strengthened vs USD, it remains competitive vs NEER. Furthermore, I believe it is unlikely that RMB will appreciate substantially more than 6.80, as existing tariffs are likely to stay under either outcome for US elections.
Some investors are concerned that PBoC may be conducting ‘stealth’ intervention against the RMB. This is based on the fact that, with a substantial surplus on the current account and pickup in portfolio inflows, the lack of FX reserve accumulation is surprising. I think the explanation is quite simple: China tends to have a ‘normal’ pace of capital flight of about USD50-100bn per quarter. This typically takes the form of unsettled FX receipts (i.e. USD that exporters have earned but not settled into RMB). These outflows vanished in Q1 due to the shutdown, but they are now probably back to normal. In addition, some local corporates may be hoarding USD for fear of potential sanctions/lack of access in the future.
PBoC appears quite relaxed about the increasing outflows, as they offset the larger trade surplus and portfolio inflows. Their day-to-day guidance through the daily USDCNY fixings has remained neutral. In other words, authorities are comfortable with the level and trend of the currency.
Chart 1
Source: Morgan Stanley Asia Macro Trading
Headwinds for the Bond Market: Floods and Supply
Flooding has affected a wide area in the upper/middle Yagtze river basin and filled the Three Gorges reservoir to near capacity. The most affected provinces are Guangxi, Guizhou, Sichuan, Hubei, and Chongqing. With more rains, flooding is extending to lower regions into Anhui, Jiangxi, and Zhejiang. You can track the latest information here (Chinese website) and here for daily rainfall.
Apart from human suffering from forced evacuations, there is concern about how this might affect food inflation. Food is 28% of the total CPI basket. Food prices have been rising since June on floods; the food component of CPI was +13.2% in July. For specific items, rice and other grains is +12% YTD/+11.2% YoY, and pork +100% YTD/+85% YoY. A more detailed breakdown is found here. Pork alone added 2.3% to headline CPI.
While the impact of flood is significant on all food crops, the most affected crop is rice. About 70% of China’s rice production comes from the upper/middle Yangtze river basin. Estimates of crop losses are imprecise at this stage, but losses are likely to be significant and worse than 2016. High base effects will keep the YoY numbers in check for the rest of the year, but food inflation will be a concern for a while. PBoC typically does not focus too much on supply shocks to food. Headline CPI will remain a problem for a while, but with core at a mere 0.5% and trending lower, it is unlikely that it will force PBoC’s to tighten.
The central bank’s immediate focus is managing liquidity amid a heavy supply overhang of CGB and local government bonds. CGB issuance was front-loaded post Covid-19, though local government bonds issuance will remain high in August and September, before trailing off in Q4. In recent weeks, PBoC has resumed liquidity injections through OMOs, and will likely maintain that support to ensure stability in the bond market. However, 7-day repo fixings have been grinding higher, and 10Y CGB yields are back above 3%. Given that market positioning in swaps is better received and foreigners have been significant buyers of bonds, these rates moves represent a pain trade for the offshore community.
Chart 2
Source: Morgan Stanley Asia Macro Trading
In short, concerns about food inflation, tight liquidity and supply are likely to keep the China rates market on the back foot in coming weeks.
Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank
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