Markets mull RMB devaluation and Fed policy link

Solomon Teague
Published on:

China’s shock RMB devaluation is unlikely to influence the Federal Reserve’s decision to hike, or otherwise, in September, but it could shape the path of subsequent increases, say analysts.

Janet Yellen time-R-600
Rate-rise timing: Federal Reserve chair Janet Yellen checks her watch

After a dovish statement from the Federal Open Market Committee (FOMC) this week, there is a disconnect between economists’ views that September is the likely start of the US monetary tightening cycle versus traders who are punting on a delay.

However, irrespective of the question surrounding a September lift-off in US interest rates, the jury is out on how China’s economic volatility will influence the Fed’s tightening course in the coming years.

Jorge Mariscal, emerging markets chief investment officer at UBS Wealth Management, thinks the People’s Bank of China would need to follow up with more devaluations before the Fed would become concerned about the prospects for global disinflation and market volatility – though the Chinese central bank has indicated it will not kick-off a devaluation spiral.

"A 3% yuan depreciation is unlikely to be sufficiently large to change the Fed’s math," says Mariscal. "A much larger one, say 10% to 20%, might, as it would mean China, the world’s second largest economy, is much weaker than expected."

Aroop Chatterjee, FX strategist at Barclays, says: "A 2% to 3% devaluation of the renminbi will have no material impact on competitiveness.

"We believe the renminbi was overvalued because of its peg to a rising dollar, so the devaluation, coupled with our expectation for weaker Chinese growth in the medium term, leaves plenty more room for renminbi depreciation before it will become a problem."

Even if the Fed were concerned about the increased competition from a weaker renminbi, those fears might be offset by more positive developments elsewhere.

"The recoveries in Europe and Japan are no doubt key positive dynamics to watch," says Mariscal at UBS. "The two combined more than make up for the slowing Chinese economy."

A prolonged round of competitive
devaluations would be damaging
Philip Uglow, MNI Indicators

It all adds up to a high conviction among observers that the Fed remains committed to action on raising rates.

The minutes from the last FOMC meeting convinced many analysts that the decision to raise rates in September has already been taken, and that it would take something truly seismic, such as a double digit fall in the S&P, to change its mind now.

William Lee, head of North America economics at Citi Research, says: "The only thing that will stop the Fed from moving on rates now is a bunker buster that destroyed the entire mosaic of US data that depicts an economy growing at 2.5% to 4%, with inflation rising to 2% after 2017."

Lee uses this metaphor advisedly. "It is a mosaic because there are so many different pieces of data reaffirming this picture and that it is time for the Fed to act," he says. "Bad data that dislodges a piece or two out of this mosaic won’t be enough."

A game-changer for the Fed would have to be an event of systemic and global significance, says Lee – something that would trigger disorderly markets, meaning a free fall in asset prices.

"A bit of volatility is easy to hedge with Vix options – that is no problem," he says. "What would be a problem would be markets in free fall, where everyone is on the same side of the trade, like with Long-Term Capital Management or the Asia crisis in the 90s."

Such a reaction looks unlikely, given the relatively muted response of equity markets to the news of the devaluation. The S&P 500 has traded in a tight 80 point range since February and the news from China did not cause it to break out of this range.

Lee says the FOMC will also be mindful of how markets would perceive a delay to its first, and keenly awaited, rate hike.

"If the FOMC decided to wait until October or even December and then move, [Fed chair Janet] Yellen would be asked what she had learned since September that had changed her mind, and that is a question she can’t answer," he says.

"If she focuses on one piece of data the market will in future focus all its attention on that data, it will destroy all the careful work the Fed has done on forward guidance."

Further reading

The future of the RMB:
special focus

However, while the FOMC is unlikely to be deterred by events in China in the short term, in the longer term, events in China might prove more influential. While US rates are unlikely to be influenced by China’s currency directly, both are driven to some extent by the same factors: global growth and risk sentiment.

Petr Krpata, FX strategist at ING, says: "The main way that China’s devaluation could influence the Fed’s decision to raise rates is if it triggers a global risk-off environment, equity prices fall meaningfully, which in turn affects US consumer confidence."

With the Fed offering so much forward guidance as to its intentions, there is little for analysts to debate in the near term – what disagreement there is concerns finer details – but what the Fed is likely to do next year, or in 2017, is far less certain.

Krpata expects the Fed to hike rates in September, but ING has revised its forecast for 2016, now predicting the Fed will only hike rates twice in 2016, down from three before China’s devaluation.

Lee says: "The path of normalization, rather than timing of lift-off, would be much more dependent on the economic and market impact of developments we saw in China. Asia represents around 25% of US trade, so if there is a slowdown in Asia we might see a more gradual path of increases, say 50 basis point rise in rates in 2016, rather than the 75bp rise we expect.