Stay long USD
USD continued to dominate the FX markets. The greenback has been benefit from aggravated stress points in other currencies. Whether is trade tensions, sanctions, Brexit concerns, European politics, exposure to oil prices or interest rates etc, the USD look to be the safe haven of choice. Even within the US-China trade battle markets are biased towards a positive US outcome. While domestically, the US continues to provide investors reasons to be satisfied with the USD outlook. Fridays US labor report was solid with unemployment fell to 3.9% and wages growth rose 2.7%. US 10- year yields jumped towards 3% providing yields seekers a meaningful spread within the G10 (although sharp retracements was seen today). Elsewhere US data has reported as expected with embeds further economic accelerations. In addition, July manufacturing employment indicated no negative effect from the USA protectionist activities. While the Fed continued to reiterate its message of gradual rate increase there is a growing case for a more aggressive hiking cycle. Especially considering that sizable upwards adjustment in personal income should support higher consumption. Jamie Dimon JPMorgan Chase & Co CEO over the weekend suggested that US 10-year bond yields could reach 5%. We continues to remain optimistic on the short-term USD outlook as other G10 currencies struggle with idiosyncratic issues. Our most negative view is on the cable as Brexit outlook remains extremely clouded. It’s hard to image after last week’s Carney comments that the BoE would tighten aggressively with risk surrounding Brexit mounting.
PBoC introduces reserve requirement amid strong Yuan depreciation
Trade tensions are intensifying, as China takes retaliatory measures, announcing additional tariffs on USD 60 billion of US imports ranging from 5% – 20% following latest threats from US side to implement a 25% tariff on USD 200 billion Chinese imports. But despite further US trade balance deficit, Asian markets pay the costs, with Shenzhen and Shanghai Composites closing at -2.08% and -1.29% respectively, Shanghai CSI 300 given at -1.27% and South Korean Kosdaq decreasing by -0.94%. Additionally, the CNY depreciation rally seems far from finished.
Accordingly, in an attempt to stabilize the currency, the PboC introduced a new measure imposing a 20% reserve requirement ratio on CNY in the forward market. Similar measures were undertaken in 3Q 2015 when the yuan went under pressure, but the relief was short-lived, as selling pressures rekindled a few weeks later.
Therefore, despite continued trade tensions, it is expected that the USD/CNY depreciation will stabilize at some point. The PBoC will be taking the necessary actions to maintain the currency below psychological level at 7. Currently trading at 6.8455, USD/CNY is showing further strength for now. We would however expect the pair to weaken slightly in the short-term, heading along 6.8220.
Bye Bye TRY
The Turkish lira remains the primary FX casualty in this risk-off environment. We are not seeing blind, unbridled EM selling, but rather the select liquidation of currencies with reveal clear faults. Turkey with a heavy USD dominated debt load has failed to play by international investors rules and are now facing the devastating consequence. The Turkish lira dropped to its weakest level as the White House indicated the US would impose sanctions on two minister of the Turkish government who were involved with the false detention of Pastor Andrew Brunson. Turkish authorities indicated Mr. Brunson is being held on terrorism charges. The violent reaction to the economically immaterial sanctions indicates just how on-edge investors are. The Turkish stock markets is the world’s worst performer in local currency, bond yields have hit a record high and the lira has dropped around 25% against the greenback this year. Last weeks sanctions aggregated a situation were President Erdogan has suggested the removal of the central banks independence. Without policy control the CBT has been unable to address surging inflation. The CBT decision not to hike rates on July 24th ,despite market expectations, is evidence of the lack of freedom. The failure of correct governance in the eyes of investors has triggers the sustained rush to the exits.
The deadly combination of a puppet central bank and out of control inflation, sent USDTRY above 5 for the first time ever. Perhaps the lira’s only saving-grace was the July inflation came in slightly lower than expected at 15.85% verse 16.30% (yet still above Junes read). However, Erdogans meddling in the CBT policy setting has prevents the bank from taking critical action to slow accelerating prices. Ergdogan has sacrificed price stability by stopping the central banks from raising rates in order to stimulate economic growth. Incredibly, Turkish interest rates at 17.75% has been too low to halt the mass exodus (real rate a paltry 1.9%). Staggering interest rate rise considering Turkey started 2018 with one-week repo rate at just 8%.
Is the lira collapse over? In our view not likely. The CBT would have to raise rates right now (not at September meeting) with a substantial hike of 300-500bp. This would incentives investors but more importantly highlight the CBT control of policy setting. However, interest rates at 20% would all but kill the Turkish economy. Erdogan is unlikely to let that happen.
