Trading CNY devaluation

The CNY devaluation last week was widely blamed for the risk aversion in the markets. The slide in the CNY pushed the Asian and EM currencies lower and the investors poured their money into safe haven assets – Gold, JPY and CHF.

It is worth noting that the CNY devaluation is likely to continue. We are likely to see rounds of CNY devaluation at regular intervals going forward. As pointed out in a report titled “Yuan in IMF's SDR basket, but long-term trend stays bearish” (Macro Scan Of 1st December 2015 ), the currency pair did rise to rising channel seen on the weekly chart.

USD/CNY Weekly chart

• The latest round of the devaluation in the CNY came to a halt at the rising channel resistance of 6.60.

• Following the sharp devaluation, the PBOC cracked down on the gap between renminbi and offshore Yuan (CNH) by buying up renminbi through state owned banks.

• Consequently, the pair fell back to low of 6.56 this week, before jumping again to 6.59 levels today.

As mentioned earlier the CNY devaluation is likely to continue at regular time intervals due to –

• PBOC’s efforts to internationalize CNY and CNY’s inclusion in SDR basket means the markets shall have more say in determining the exchange rate. This points to CNY weakness

• China rebalancing is not even half way through (rebalancing = consumption driven = high imports). This coupled with aggregate demand deficiency in the global economy means the CNY is on a long-term bear trend.

When is the next round of CNY devaluation?

The answer lies in the weekly USD/CNY chart. The last round of the devaluation was seen in August, following which the pair moved slowly lower till November. The Fed rate hike in December pulled up USD/CNY before another round of CNY devaluation pushed the currency pair to 6.60.

On similar lines, we could see a sideways to negative action in the USD/CNY till March-April, post which another round of CNY devaluation could be expected.

With that in mind, it would be worth noting which other currencies/assets could be traded during/ahead of the next round of CNY devaluation.

Japanese Yen – The common sense logic is a sharp drop in the CNY eats away Japanese exports and hence markets sell JPY in anticipation of a retaliatory action from the BOJ. However, JPY is likely to be a top beneficiary in future as well since CNY drop triggers risk aversion and increases demand for the safe haven JPY.

Asian and EM currencies – Currencies of the Asian and EM economies are strongly correlated to the Chinese Yuan. The logic is again the same - a strong currency at a time when manufacturing competitors such as Japan and China have weaker currencies leads to a sharp fall in exports. A look at the performance of the Asian/EM currencies gives a clear picture.

During the next round of CNY devaluation or heading into the next round of devaluation, the currencies like INR appear attractive against Asian and EM currencies with high dependency on exports like THB, BRL, ZAR. The Indian Rupee appears comparatively resilient due to better-performing economy (consumption driven) and ability to stockpile large foreign currency reserve positions.

Other attractive asset is Gold in Asian currency terms. The yellow metal always turns out to be a major beneficiary of the currency debasement. Moreover, the demand for Gold from Asia could continue to rise throughout 2016, lending support to the Gold prices in the USD terms as well.

Treasuries and Bunds may not be attractive in future - Investors also prefer piling their money into safe haven assets - US treasuries and German bunds. However, markets are likely to come to terms with the slow and steady drop in Yuan at regular intervals. Hence, the degree of risk aversion could drop with each round of CNY devaluation. Hence, Treasuries and Bunds may not be major beneficiaries.