Outlook:

In normal times, one of the key data points is the PMI, used in recent years as a proxy for the robustness of growth. This is an improvement over earlier years when indirect data was the obsession, especially money supply and inflation (and before that, trade). From those you have to deduce business confidence and growth, whereas PMI’s are more direct. Therefore, today’s crop of PMI’s is not unimportant and today’s US service sector PMI (and factory orders) will be a focus, especially in contrast to the UK and eurozone—but having said that, market shenanigans are far more stimulating than any dull old economic data.

And when it comes to market shenanigans, China is taking the cake these days. Traders trying to look ahead more than a day have to be wondering what the Chinese think they will accomplish over the next few months. What is the end-game? In order to preserve reserve currency status—prematurely conferred by the IMF in November—China has to demonstrate the yuan can be widely and easily used as a numeraire in trade and capital flows.

The very existence of an onshore and offshore yuan makes fulfilling that criterion a joke. Having two versions of the same currency explicitly means the currency is not freely traded and the price is not set solely by market forces. It’s a bit reminiscent of the two Belgian francs from the 1970’s, one for trade and one for capital (or Venezuela in the early 1980’s). A two-currency regime is always and every-where an indication of a failed financial system.

A two-currency regime never works because it inevitably brings out the worst in everyone and encourages players to engage in fraud. Just as China is committed to rooting out corruption in government, it is rewarding the private sector for fraud by the very existence of two currencies. Logically, the final goal is to merge the two currencies.

The problem, of course, is that a market-determined yuan would probably be a whole lot lower at a time when China is pretending not to seek a “currency war” devaluation. According to the FT yesterday, the daily fix seems to be setting the pace of the currency move, not the direction. But the divergence between the onshore and offshore yuan is at the widest ever, implying the Chinese government accepts that devaluation is what the market wants. This is a bit embarrassing, since in August the one-time devaluation was supposed to close the gap and keep it small, hiding the bigger embarrassment of having two currencies in the first place.

Today the FT reports Goldman Sachs is just one of the big players worried that a faster devaluation will destabilize the economy as well as set off a currency war among China’s trade competitors. As of the hand-off from China to London today, so far this week the yuan has fallen over 2%--about the same as the official deval in Aug, in only three days.

Bloomberg reports today the PBOC lowered the fixing by 0.22% to the weakest level since April 2011.

The offshore yuan fell 1% in Hong Kong to the lowest since September 2010. The contagion was swift. “Malaysia’s ringgit, Russia’s ruble, Turkey’s lira and the South African rand slid at least 0.6 percent as the measure of 20 developing-nation currencies dropped 0.5 percent. South Korea’s won fell 0.8 percent to the weakest level since September while the equity benchmark slipped 0.3 percent.”

So, one of the top worries for the year 2016 is already materializing in the first week. The good news is that the problem might get solved in the first half and we won’t be holding our breath all year for the other shoe to drop. But there is no win for China here. It’s going to look cack-handed no matter what it does. If it were to liberate the yuan so as to combine the two versions, it risks a market-driven devaluation accompanied by vast capital flight. Most economists would favor this strategy—let the market decide and let the chips fall where they may. Merging the two but with capital controls is probably more practical, but again, capital controls invite citizens to become fraudsters. Well, they are used to that in command economies.

One little thing—the NYT reports UK importers from China can’t get the Chinese suppliers to accept yuan. They still want dollars. A stern telephone call could fix that one—and needs to get done. After all, a reserve currency must be “used” and that means by the country of origin, too.

Delay and dithering in merging the two currencies is probably what we will get, though. And every time China tries for regulations and restrictions to get around the market’s clear preference for depreciation, it will be accused of botching things and being incompetent. It’s not incompetent—it just faces a rock and a hard place. Also, the markets never really get accustomed to China’s efforts to herd its currency cats. Every time it tries something, the rest of the world will over-react—as we saw this week and last August. The future promises volatility, which is presumably nice for the options guys if no one else.

Returning to the non-China world, this week has big data in the US. Some go so far as to say it’s a critical day and week, and everything will be different afterwards. Poppycock. Still, we get the ADP private sector payrolls estimate, MBA mortgage data, the trade deficit, factory orders, nonmanufacturing ISM, Markit PMI and the minutes from the Fed's December meeting—culminating in payrolls on Friday.

Today if you are free at 8:30 am ET, tune in to CNBC for Stanley Fischer. The Fed Vice Chairman often has Messages to deliver. Later this afternoon we get the minutes of the last Fed meeting at which the first hike was decided. Some analysts think the minutes will be fun. We say they will be anything but fun, especially because the probability of getting clarity is close to zero. We will not find out what “gradual” means or whether the Fed can honestly be predicting inflation, and in the absence of inflation, can a drop in unemployment under 5% be a substitute?

Strategic Currency Briefing

CurrentSignalSignalSignal
CurrencySpotPositionStrengthDateRateGain/Loss
USD/JPY118.31SHORT USDSTRONG12/28/15120.481.80%
GBP/USD1.4651SHORT GBPSTRONG11/06/151.51373.21%
EUR/USD1.0745SHORT EUROWEAK01/04/161.09051.47%
EUR/JPY127.13SHORT EUROSTRONG12/04/15132.383.97%
EUR/GBP0.7333LONG EUROWEAK10/23/150.71941.93%
USD/CHF1.0093LONG USDSTRONG01/04/160.99791.14%
USD/CAD1.4087LONG USDSTRONG10/28/151.32356.44%
NZD/USD0.6645LONG NZDWEAK12/04/150.66410.06%
AUD/USD0.7072LONG AUDWEAK01/04/160.7212-1.94%
AUD/JPY83.68SHORT AUDSTRONG12/10/1588.805.77%
USD/MXN17.4677LONG USDWEAK12/07/1516.72584.44%

This morning FX briefing is an information service, not a trading system. All trade recommendations are included in the afternoon report.

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