Revaluing China's Currency Move

Maybe the knee-jerk reaction of a weaker dollar and higher bond yields was a harbinger.
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With a night of sleep helping to digest China's

historic first step toward revaluing the yuan, the long-term implications of the move are becoming clearer. The days of the strong dollar may be numbered and long-term interest rates may finally start rising substantially in the U.S.

Given the small-scope of the revaluation -- a little over 2%- -- of the yuan against the dollar on an immediate basis, dollar weakness on Thursday, especially against the yen, may be described as simply a knee-jerk reaction.

Indeed, the dollar gained back some ground against the yen by Friday, after losing more than 2% against the Japanese currency Thursday. Against the euro, the dollar was little changed midday Friday after losing 0.2% Thursday.

Similarly, the benchmark 10-year bond was gaining 12/32 in price and its yield fell to 4.24%, after plunging almost an entire basis point Thursday. (Major stock averages were mixed midday, with strength in oil service stocks such as

Halliburton

(HAL) - Get Report

and

Schlumberger

(SLB) - Get Report

helping to offset weakness in tech bellwethers

Microsoft

(MSFT) - Get Report

and

Google

(GOOG) - Get Report

.)

Even so, Thursday's reaction in the fixed-income and currency markets was probably the correct one. "This knee-jerk reaction was indicative of the market coming to terms with the trend that we'll have weaker dollar and higher Treasury

yields going forward," says Michael Gregory, fixed-income strategist with BMO Nesbitt Burns.

The rationale goes like this: Chinese and other Asian central banks such as Malaysia -- which followed China's move -- Singapore and Hong Kong, won't need to purchase as many dollars to manage their currency regimes. Those dollars were mostly recycled to purchase U.S. Treasuries and other assets.

"Revaluation means that a big buyer of U.S. Treasuries is leaving the market and the prospect of that occurring has already hit bonds hard," says Kathy Lien, chief strategist at Daily FX.

The Chinese central bank still has to announce the components of the currency basket it will now use to control the value of the yuan. But it's very likely that the bank will step up its purchase of euros and yen and recycle them into eurozone and Japanese government bonds, Lien says.

China's trade with the European Union accounts for 18.5% of its overall trade, compared with 18% with Japan and 17.5% with the U.S.

Of course, the extent of dollar weakness will be conditional on how much and how quickly China lets the yuan appreciate. China, second to Japan as the largest holder of U.S. Treasuries, wouldn't want to see the value of its assets weaken dramatically, so will probably try to scale the process. "They don't want to shoot themselves in the foot," says BMO's Gregory.

But according to Richard Berner, equity strategist with Morgan Stanley, China's move "takes away an element of uncertainty in capital markets that encouraged private capital in search of yield to flow into the U.S."

In a way, China and Malaysia's move toward revaluation also allows the dollar to return to its prior cycle of weakness. With only free-market mechanisms at work, the adjustment process should have had the dollar continuing to weaken this year to reflect the huge U.S. trade and current account deficits. Eventually, dollar weakness would reduce imports and boost exports.

But until now, the dollar could not freely depreciate against China and other Asian countries, which also account for a large portion of the trade deficit. The adjustment process therefore took place through the appreciation of other freely floating major currencies, such as the yen, the Canadian dollar and the euro.

The other fixed-income implication of a stronger yuan and a weaker dollar is through inflation expectations, which are reflected in longer-term bond yields. Cheap goods and cheap labor from China and other Asian countries have kept a lid on inflationary pressures in the U.S. and globally. But the risk is that imports and production costs will start to become more expensive.

Federal Reserve

Chairman Alan Greenspan, speaking during the second day of his semi-annual testimony to Congress on Thursday, cited dollar strength as providing relief on the inflation front.

Morgan Stanley's Berner has long held that long-term U.S. yields were unsustainably low. "Given that valuation risk, we cannot rule out the possibility that the China story could be an important trading catalyst -- in conjunction with Greenspan's moderately hawkish message and increasingly positive economic data -- for a further bond market correction," he wrote to clients.

The good news (from the Fed's perspective) is that a substantial rise in long-term yields may finally help cool demand in the red-hot U.S. housing market. The yield of the 10-year Treasury bond is used as a benchmark to set mortgage rates. A cooling in house appreciation, against which U.S. consumers have been borrowing to finance purchases, would therefore also help cool U.S. consumption and inflation pressures. Should this happen, the Fed would then have less of a need to continue raising short-term interest rates.

That prospect, of course, is not bullish for the U.S. dollar. The greenback has been supported this year by the prospect of higher U.S. rates. But that link may be waning going forward. Already in recent action, the dollar has failed to react positively to hawkish news -- such as Greenspan's first day of testimony on Wednesday, according to Goldman Sachs currency strategists.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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