Eyes on Yellen (and global macro)

As we are getting close to the FOMC statement release, I was reading some articles over the past couple of days to understand the recent spike in volatility. Whether it is coming from a ‘Brexit’ fear scenario, widening spreads between core and peripheral countries in the Eurozone (German 10Y Bund now trading negative at -0.5bps), disappointing news coming from US policymakers this evening or more probably from something that I don’t know, I came across some interesting data.

First of all, I would like to introduce an indicator that is getting more and more popular these days: Goldman’s Current Activity Indicator (CAI). This indicator gives a more accurate reflection of the nation’s GDP and can be used in near real-time due to its intra-month updates. It incorporates 56 indicators, and showed a 1-percent drop in May to 1.2% due to poor figures in the labor market and ISM manufacturing data (see chart below).

Chart 1. Goldman CAI (Source: Bloomberg)


The implied probability of a rate hike tonight is less than 2% according to the CME Group FedWatch, and stands only at 22.5% for the July meeting. If we have a look at the Fed Dot Plot’s function in Bloomberg, we can see that the implied FF rates curve has decreased (purple line) compare to where it was after the last FOMC meeting (red line), meaning that the market is very reluctant to a rate hike in the US.

Chart 2. US Feds Dot Plot vs. Implied FF rates (Source: Bloomberg)


June hike, why not?

Many people have tried to convince me of a ‘no June hike’ scenario, however I try to understand why it isn’t a good moment for Yellen to tighten. Oil (WTI CL1) recovered sharply from its mid-February lows ($26/bbl) and now trades slightly below $48 (decreasing the default rate of the US high-yield companies), the US Dollar has been very quiet over the past 18 months (therefore not hurting the US companies’ earnings), the SP500 index is still trading above 2000, the unemployment rate stands at 4.7% (at Full employment) and the Core CPI index came in at 2.1% YoY in April.

However, it seems that US policymakers may have some other issues in mind: is it Eurozone and its collapsing banking sector, Brexit fear (i.e. no action until the referendum is released), CNY series of devaluation or Japanese sluggish market (i.e. JPY strength)?

The negative yield storm

According to a Fitch analysis, the amount of global sovereign debt trading with negative yields surpassed 10tr USD in May, with now the German 10Y Bund trading at -0.5%bps. According to DB research (see chart below), the German 10Y yield is the ‘simple indicator of a broken financial system’ and joins the pessimism in the banks’ strategy department. It seems that there has never been so much pessimism concerning the market’s outlook (12 months) coming from the sell-side research; do the sell-side firms now agree with the smart money managers (Carl Icahn, Stan Druckenmiller, Geroge Soros..)?

Chart 3. German 10Y Bund yield (Source: DB)

10Y bund DB.jpg

ECB Bazooka

In addition, thanks to the ECB’s QE (and CSPP program), there are 16% of Europe’s IG Corporate Bonds’ yield trading in negative territory, which represents roughly 440bn Euros out of the outstanding 2.8tr Euros according to Tradeweb data. If this situation remains, sovereign bonds will trade even more negative in the coming months, bringing more investors in the US where the 10Y stands at 1.61% and the 30Y at 2.40%. If we look at the yield curve, we can see that the curve flattened over the past year can investors could expect potentially LT US rates to decrease to lower levels if the extreme MP divergence continues, which can increase the value of Gold to 1,300 USD per ounce.

Chart 4. US Yield Curve (Flattened over the past year)


(Source: Bloomberg)

Poor European equities (and Banks)

However, it seems that the situation is still very poor for European equities, Eurostoxx 50 is down almost 10% since the beginning of June, led by the big banks trading at record lows (Deutsche Bank at €13.3 a share, Credit Suisse at €11.70 a share). The situation is clearly concerning when it comes to banks in Europe, and until we haven’t restructured and/or deleveraged these banks, systemic risk will endure, leaving equities flat (despite 80bn Euros of money printing each month). Maybe Yellen is concerned about the European banks?


Another issue that could explain a status quo tonight could be the rising fear of a Brexit scenario. According to the Brexit poll tracker, leave has gained ground over the closing stages, (with 47% of polls for ‘Brexit’ vs. 44% for ‘Bremain’). This new development sent back the pound to 1.41 against the US Dollar, and we could potentially see further Cable weakness toward 1.40 in the coming days ahead of the results. Many people see a Brexit scenario very probable, raising the financial and contagions risks and the longer-term impact on global growth. It didn’t stop the 10Y UK Gilt yield to crater (now trading at 1.12%, vs. 1.6% in May), however a Brexit surprise could continue to send the 5Y CDS to new highs (see below).

Figure 1.  FT’s Brexit poll tracker (Source: Financial Times)


Chart 5. UK 5Y CDS (Source: Bloomberg)


CNY devaluation: a problem for US policymakers?

Eventually, another problem is the CNY devaluation we saw since the beginning of April. The Chinese Yuan now stands now at its highest level since February 2011 against the greenback (USDCNY trading at around 6.60). I am sure the Fed won’t mention it in its FOMC statement, but this could also be a reason for not tightening tonight.

Conclusion: a rate hike is still possible tonight

To conclude, I am a bit skeptical why the market is so reluctant for a rate hike this evening, and I still think there is a chance of a 25bps hike based on the current market situation. I don’t believe that a the terrible NFP print (38K in May) could change the US policymakers’ decision. Moreover, even though we saw a bit of volatility in the past week (VIX spiked to 22 yesterday), equities are still trading well above 2,000 (SP500 trading at 2,082 at the moment) and the market may not be in the same situation in July or September.

Quick review of the Chinese Yuan history

Back in November 2014, I wrote a quick summary of my favorite currency: the Japanese Yen. It was a very useful exercise for me first of all, and I hope it provided interesting information for my readers.

I think this time an interesting story of a particular currency that I tend to watch every morning is the Chinese Yuan or ‘Renminbi’. The difference between the two names: the Yuan is the name of a unit of the renminbi currency (i.e. you can say that a slice of pizza cost 10 Yuan, but not 10 renminbi.

The ‘Dark’ Beginnings… 

The Renminbi, which literately means ‘people’s money’, is the official currency of the People’s Republic of China (PRC). It was first issued on December 1st, 1948 by the PBoC, Public’s Bank of China, the country’s central bank. The bank was established on the same date under the Chinese Communist Party ruled by the Chairman Mao Zedong (also known as the founding father of the PRC). China experienced a massive monetary inflation between 1937 and 1945 (end of WWII) in order to fund the war with Japan. Studies showed that between 70 and 80 percent of the annual expenditures were covered by fresh printed money during that period. Therefore, the country suffered from a Great Inflation in the same years that was reflected on the exchange rate. Here are some figures (coming from the work of Richard M. Ebeling, the Great Chinese Inflation, 2010):

  • In June 1937, one US dollar was traded at 3.41 against the Yuan
  • By December 1961, the exchange rate of USDCNY rose to 18.93 in the black market
  • At the end of WWII, the Yuan depreciated dramatically to 1,222 (vs. the greenback)
  • In May 1949, USDCNY reached a dramatic 23,280,000

In the 1950s, the Chinese economy was so cut off from the rest of the world that it is difficult to find data on a potential meaningful exchange rate. All the information I have so far is that a second issuance of Renminbi took place in 1955 and replaced the first one at a rate of one new CNY to 10,000 old CNY.

The World Bank published an annual average middle exchange rate for US Dollar to Chinese Yuan since 1960. Between 1960 and 1971, one US dollar was worth 2.4618 Chinese Yuan, which makes me believe that China was ‘also part of’ the Bretton Woods agreements (I am speculating on that information based on the ‘pegged’ exchange rate). Then, after the Nixon ‘shock’, the exchange rate started to depreciate and reached a low of 1.8578 in 1977 before starting to soar to 2.40 in 1980.

The 1980s reform and RMB Devaluation:

With China’s economic reform in the 1980s, the Yuan started to become a more easily traded currency (exchange rate was therefore more realistic), thus data became public. The following historical exchange rates are based on Bloomberg (ticker: CNY BGN Curncy).

Starting with a grossly overvalued exchange rate in 1980, the Chinese Yuan experience a series of devaluation until the late 1990s until the Chinese authority settled the rate 8.27 CNY/USD.

As you can see it on chart 1, the rise of the US Dollar under the Reagan Administration (as a consequence of the Fed rising interest rate to 20% to counter inflation coming from the second oil shock) pushed the USDCNY exchange rate  from 1.65 to roughly 3.00 in September 1985 (before the Plaza Accord on September 22nd). In contrast, the real exchange rate was more much stable and remained virtually constant between 1981 and 1985 (during this period, the Renminbi was pegged to a back a basket of internationally traded currencies weighted according to their importance of China’s trade).

Between 1987 and the end of 1990, the Chinese Yuan was relatively pegged to the US Dollar, with a 26% Yuan devaluation that took place in the last quarter of 1989. However, these devaluations were not sufficient with the emergence of a black market pricing a much higher USDCNY exchange rate (i.e. cheaper Yuan currency against the US Dollar). Therefore, the ‘unofficial’ floating rate (a swap market rate) has constantly driven the ‘official’ rate (nominal rate on chart 1) until the massive devaluation of 1994 (and the official and ‘unofficial’ rates were eventually unified).

1995: The start of a new regime

One the two rates were unified, the Chinese currency was pegged to the US Dollar from 1995 to 2005 at an exchange rate of 8.28 Yuan per US Dollar. Therefore, the PBoC was ready to intervene (i.e. buy or sell Yuan) in the market to keep that rate steady. This policy was combined with a policy of restricting international capital flows, where the citizens were not allowed to convert savings into US dollars, Japanese Yen or British pound.

In consequence, the low exchange rate lead to political issues between US and China as many studies concluded that the Chinese Yuan was an undervalued currency. Exports were growing dramatically in China (see appendix 1), from 160 million US dollars in 1995 to 600 million dollars in 2005 according to the General Administration of Customs. The economic modernization, cheap labour costs in addition to a more ‘transparent’ exchange rate led to a surge in Foreign Direct Investment during the 1990s and 2000s. The economy average an average annual growth rate of 9-10% between 1995 and 2005 (appendix 2).

China’s economic growth and trade liberalization led to a sharp expansion in US/China commercial ties, and a constantly increasing US trade deficit with China. If we look at table 1, the US trade balance deficit widened from USD 10.4bn to USD 201.6bn in 2005, damaging the US economy. There are many reasons why China could have resisted from international pressures to maintain it peg during that period, but the two main ones that come to my mind is that China was mostly financing the US deficit (i.e. purchasing US Treasuries) and the US manufacturing was benefiting from cheap labour costs for goods produced in China.

The 2005 peg removal

Eventually, the PBoC removed the peg on July 21st 2005 and allowed a first one time appreciation of 2.1%, pushing the dollar down to 8.11 CNY. From there, China allowed its currency to float within a range determined in a relation to a basket of currencies (authorities told the world that it ran a ‘managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies’). The basked was dominated by its main trading partners – US Dollar, Euro, Japanese Yen and South Korean Won – with a smaller proportion of other currencies (GBP, AUD, RUB, CAD, THB and SGD). Until Q3 2008, USDCNY fell roughly 18% before the reintroduction of a de facto peg during the financial crisis from 2008 to mid-2010 at around 6.80 Yuan per dollar.

June 2010: A return to the daily trading band limit:

In June 2010, after a two-year peg, China allowed once again USDCNY to trade within a 0.5% band (daily limit for appreciation or depreciation of the CNY against the USD) amidst major pressure from international trade partners. The Yuan’s trading band was then widened to 1 percent in April 2012, which led to further appreciation of CNY (USDCNY fell another 11.60% to reach a low of 6.01 in January 2014).

The Yuan crisis in Q1 2014

In the start of 2014, we saw a little Yuan crisis with USDCNY erasing most of its Jun-2012 / Jan-2014 fall (62% roughly if we look at chart 2). There are many stories that could describe this sudden CNY collapse:

  • the PBoC willingness to join the global currency war and enhance export
  • the carry trade unwinds from structured products build on the hypothesis that the Yuan will appreciate continuously (FX Target Redemption Forward story for instance)
  • other thought that the PBoC was paving ‘the way for further liberalization of the Yuan exchange rate’

I think the carry trade unwinds is the most appropriate based on the one-way market positioning concerning the Yuan before that crisis. Products were structured by banks on the hypothesis that the Chinese Yuan will constantly rise against the USD until it eventually reached its ‘fair value’ which was estimated between 5 and 5.5 at that time (BEER, FEER fair value models). We know that carry trade currencies tend to depreciate gradually during some period so that carry traders could benefit from the interest rate differentials, however the risk-off aversion (i.e. carry unwind) is sudden and very drastic.

In mid-March 2014, the PBoC widened the range to 2 percent (allowing the exchange rate to rise or fall 2 percent from a daily midpoint rate that the central bank sets each morning). Until the August 11 devaluation that occurred the following year, the Chinese Yuan oscillated at around 6.20 against the Dollar.

August Devaluation

On August 11th, the PBoC suddenly allowed the Yuan to depreciate by nearly 2% against the USD, its largest devaluation in the past two decades amid slower economic growth and a depressed highly-volatile stock market. As you can see it on Chart 3, the Shanghai Shenzhen Index (CSI 300) started to enter into a bear market in June 2015 after it reached a high of 5,380. In the beginning of August 2015, the market was almost down 2,000 pts. and the fear of a ‘Chinese bubble collapse’ raised concerns over global investors. A second PBoC move was done the consecutive day and pushed the total devaluation to nearly 4 percent (from 6.21 to 6.44 USDCNY, see chart 4).

Watch the CNY – CNH spread

As China has been opening up its economy to the RoW (Rest of the World) since the late 2000s, the officials’ goal was to internationalize its currency to the market to settle trade and financial transactions. As you know, the CNY – or on-shore Yuan – is not allowed outside of China and is only convertible in the current account (i.e. trade) and not in the capital account (i.e. for investments and banking flows). Thus was born the CNH in 2009 – offshore Renminbi – which circulates in offshore markets such as Hong Kong (China Mainland Hub). Since then, there has been a rapid expansion of offshore clearing centres in financial cities like London or Frankfurt and the RMB has begun direct currency trading against the Euro, GBP, NZD in addition to USD, JPY or AUD.

The important criteria of the CNH is that it is allowed to float freely with no restrictions on cross border trade settlements, therefore I usually like to watch the CNY – CNH spread just to see the divergence sometimes that happens in the market (See chart 5). In the beginning of the year 2016, we saw a massive divergence between USDCNY and USDCNH, with the offshore Yuan (CNH) was depreciating at a much faster pace than the on-shore Yuan (CNY). On January 6th, the spread reached 14 figures, with USDCNY trading at 6.55 and USDCNH at 6.69. Eventually, the situation stabilized and the two exchange rates converged.

I think that by looking at the spread between the two rates, you can gauge the market’s perception toward the currency and its confidence in the PBoC’s policies.

Will the Yuan continue to weaken in the near term?

It has been a few years now that a group of investors have been watching closely China, especially its highly-leverage banking system. Over the past decade, China has expanded its credit market from 5tr USD to 35 trillion USD; for an economy of roughly 10tr USD, the banks’ total-assets-to-GDP ratio stands at 350%. China is massively exposed to the housing market, which represents roughly 15 percent of the country’s GDP (it was 5% in the US before GFC). Therefore, if the housing market halts or starts to decline (which it has already according to some housing market index), the country could be exposed to a non-performing loans cycle and therefore would be forced to recap its banking system, pushing the PBoC to increase its balance sheet. As China doesn’t offer short positions in equities (not very common from my knowledge) and no structured products or derivatives to short the housing market, people are positioned in the currency, expecting a ten to twenty percent depreciation. This scenario could bring the currency USDCNH somewhere between 7 and 8.

Chart 1. Historical USDCNY exchange rates (Source: Bloomberg)


Chart 2. The 2014 USDCNY ‘crisis’ (Source: Bloomberg)


Chart 3. CSI 300 Index (Source: Bloomberg)


Chart 4. China CNY devaluation – August 11th


Chart 5. CNY – CNH spread (Source: Bloomberg)


Appendix 1. Exports (Source: Trading Economics)


Appendix 2. Growth (Source: Trading Economics)


Table 1. US trade with China (US ITCD)


Ahead of the ECB and Fed meetings: watch the VIX

In this very quiet week, the SP500 is once again ‘playing’ with the 2,100 level and I strongly believe that it could be a perfect time to go short if you think about the upside / downside risk. There are many events coming up starting with the ECB meeting tomorrow and Non-Farm Payrolls on Friday. I guess we could see some volatility coming from these events which could impact equities and the FX market. As I wrote here, we saw that usually EURUSD tends to be positively correlated to sudden rise in volatility. Even though we expect the ECB to keep its rates steady (deposit at -0.4%, refi at 0% and marginal lending facility at 0.25%) with no increase in the current 80-billion-euro QE program, the market may react negatively during Draghi’s conference starting 1.30pm. Once again, the ECB could disappoint, leading to equities sell-off and some Euro appreciation. As you can see it in the chart below, EURUSD has entered in a bearish trend since May 3rd, decreasing by 5 figures until it hit its 200-SMA (yellow line) at 1.11. It has been trading within a 90-pip range over the past 3 days and I expect the currency pair to stay rangy today as well; however I would pay attention to the potential spike we can see tomorrow. The first strong resistance on the upside stands at 1.1250, a breakout could directly lead us towards the 1.1350 – 1.1400 range.


(Source: Bloomberg)

In addition, US non-farm payrolls could disappoint on Friday (Bloomberg survey at 160K) leading to another round of equity sell-off, sending the US 10-year yield back below 1.8% and pushing the Euro to higher levels. If we look back at the beginning-the-year sell-off in the chart below, the SP500 (candlesticks) fell by more than 200pts, the US 10-year (red line) crashed from 2.3% to 1.66% while the Euro (green line) surged by 7 figures to almost 1.14 against the greenback.


(Source: Bloomberg)

Another reason to go short US equities at the moment could be a good strategy to hedge yourself against a volatility spike ahead of the FOMC meeting (June 14/15). If we look at the FedWatch Tool developed in the CME website, there is a 22.5% implied probability of a rate hike based on the CME 30-day Fed Funds futures prices.


(Source: CME Group)

However, the odds are higher based on the last few speeches delivered by US policymakers and of course a quiet market. In her 30-minute Q&A session with Greg Mankiw at Harvard on Friday, Fed Chairman Yellen said that the economy was continuing to improve and that a ‘rate hike in coming months may be appropriate’. In my opinion, I think a June move is appropriate, especially if equities still trade above 2,000 until that meeting. In addition, if we look at the Eurodollar futures market, time deposits denominated in US dollars and held at banks outside of the United States, the June contract trades 99.28 (i.e. the implied rates is at 72bps). Eurodollar contracts are useful to look at as well as they are more liquid than Fed Funds futures.

The only reason I see for no rate hike this meeting is if we see another sharp sell off within the next couple of weeks.