On Tuesday, China devalued the yuan by 1.9%, roiling global markets. China had been pegging tightly to the dollar in order to boost the prospect of unseating the US dollar as a reserve currency. China has also supposedly been trying to transition away from being primarily an export economy, putting more emphasis on domestic consumption, especially for services. However, the combination of slowing global trade and a looming rate hike by the Federal Reserve caused other Asian currencies to weaken significantly to the dollar. With the yuan pegged to the dollar, the net effect was that China was ceding export markets to other competitors. In an economy already laboring under the weight of bad debts and slowing growth, China decided to cut the value of its currency. In other words, China dropped the prices of their exports. Not particularly good news for countries like Korea and Indonesia, whose currencies both immediately made new lows vs the USD.
So what’s it mean? Think of those Walmart commercials where the big yellow smiley face falls down and reveals the new lower price…”Falling prices”. But don’t take my word for it. On Tuesday copper fell over 6 cents to test new lows. Lumber dropped $10 to 249.20. Crude oil (CLU5) probed below $43, which was down over $2 bbl. The market concluded that problems in China are larger than first thought, and translated the idea of currency wars into DISINFLATION. Note that yields at the longer end of the treasury curve, which are more sensitive to inflationary expectations, fell hard, with the ten year note yield down 10 bps on Tuesday to just 2.137%.
There is some talk that this move by China will forestall a September hike by the Fed, which had been priced at a bit over 50/50 odds on Monday. Once again, let’s examine what some of the Eurodollar calendar spreads are telling us. The peak one-year calendar spread on the Eurodollar curve is the spread between December 2005 and December 2006 (EDZ5/EDZ6). On Tuesday the spread declined by 4.5 bps to 75, as low of a settle as the spread has had since late April. Over the past few months, the range in this spread has been 75 to 92.5. In a simplistic sense, a spread of 75 bps or 3/4pct, suggests that the market believes there will be three 25 bps hikes by the central bank over that year. Probably a reasonable assumption given the Fed’s constant assurances that rate increases will be “gradual”. If this spread starts falling into the 60’s it would signal the idea of much slower forward economic growth in the US.
Alex Manzara
