RMB Short Squeeze, FED talk and JPY

The RMB short squeeze taking USDCNH back down to levels seen around the US election day seems complete. CNH HIBOR O/N rates at 60% as well as the sell-off in long-end of China yield curve are not durable options for a highly leveraged/overcapacity-running economy. This morning China’s Economic Information Daily calling the recent surge of commodity prices more a financial phenomenon than a result of demand exceeding supply comes close calling the housing market a bubble. Against this background, the PBoC has moved away from its super easy monetary policy approach it implemented in 2015.

China Securities Daily highlighted property developers using foreign currency denominated funds as a substitution for tighter RMB liquidity conditions. Concretely, overseas financing for 40 key Chinese property developers totalled CNY16.7 bln in December, almost tripling from November. Hence, the RMB squeeze did not only send a warning shot to speculative carry trade investors using the RMB as a funding tool, it may also be designed to ease some local balance sheet pressures for those Chinese corporations trying to compensate for tighter RMB funding conditions by funding via non-RMB denominated instruments. However, there is a third and probably most important aspect to consider. After 40 years of over-monetisation China runs excessive balance sheets with liabilities primarily locally funded. The problem is that RMB denominated asset holders aim for currency diversification which would ultimately reduce RMB denominated funding sources. Local capital costs would rise undesirably.

From a global risk perspective it has been good to see China dealing with such pressures pre-emptively, explaining why FX volatility has not spilled over into global equity markets. Instead, China’s RMB squeeze may prove good news for the global reflation trade. Meanwhile, price action seems to generate technical talk explaining why the USD may have topped and may fall further from here. This talk circles around the state of the US economy and whether those expectations concerning ‘Trump economics’ would be too inflated and hence already priced in the USD. Here we raise two topics.

 First, a comment from San Francisco Fed’s Williams calling expectations of three rate hikes for this year reasonable citing the 2% growing economy, the inflation rate moving back to the Fed’s 2% target and full employment as reasons for the Fed turning more hawkish. Interestingly, he added any fiscal stimulus out of the Republican-controlled White House and Congress would have just a modest effect on growth over the medium term, though President-elect Donald Trump’s pledges to cut taxes and unleash government spending will likely cause the economy to grow slightly faster. Williams seems to suggest that the output gap-closing US economy would have to aim for higher interest rates anyway and that the fiscal expansion plan of the incoming government may add to upward rate pressures.

Output gap differentials and flow of funds. Secondly, the BoJ and the ECB as the Fed’s main global counterparts will stay accommodative and over-leveraged and overcapacity-running Asia will have to run through a period of saving, generating balance sheet consolidations. These savings will aim for higher yield and, in the absence of finding adequate investment returns locally, will have to leave the region leading to AXJ currency weakness. Since the USD is used as a local reference currency, these domestic excess savings should find its way into the US.

The release of Japan’s weekly security flow data underlines the reflation link of our JPY bear projections. In the last week of December, Japan saw a JPY3.4895trn money market outflow, representing the highest outflow since 16 March 2016. The JPY has re-emerged as a global funding currency suggesting the trend of JPY weakness will resume with calming RMB markets and a potentially strong US labour market report working as the catalyst. Technically, USDJPY closed the post December Fed opening gap at 115.10. Should today’s US labour market report hold strong as the initial claims report has indicated for some time (Exhibit below) then the USD will re-enter its upward trend today.