Stronger Yuan Leads to Weaker Stocks

Treasuries are hit even harder as traders contemplate the meaning of China's first step to floating its currency.
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So much for the summer doldrums. Market players, busy sifting through earnings and anticipating Alan Greenspan's second day of testimony to Congress, were shocked by news of more explosions in London and by China's move toward revaluing the yuan.

"We sure had a combination of a lot of factors that took the market down today," says Marc Pado, market strategist at Cantor Fitzgerald.

Major stock proxies first slumped in the morning after reports of explosions revived panic in London after bombs killed more than 50 two weeks ago.

But the chatter on Wall Street was dominated by China's move toward revaluation, which weakened the dollar and sent bonds tumbling.

The move also fueled concerns that U.S. companies that rely heavily on importing cheap Chinese goods may see their margins squeezed. "Besides the obvious positives

of a yuan revaluation for U.S. exports, I never bought the case for being optimistic about this in the short term," Pado says. "Somebody is going to be pressured."

Initial targets included retailers such as

Wal-Mart

(WMT) - Get Report

,

Target

(TGT) - Get Report

and

Sears

(SHLD)

, down between 0.6% and 2.9%.

The

Dow Jones Industrial Average

I:DJI

, which fell first 81 points after the London explosions, eventually settled 61.38 points, or 0.57%, lower at 10,627.77.

The

Nasdaq Composite

(NASDAQ)

fell 9.97 points, or 0.5%, to 2178.6. After hitting a four-year high Wednesday, the tech-heavy index was originally poised to gain after

eBay's

(EBAY) - Get Report

earnings beat expectations by a wide margin. The stock soared more than 20%.

The Nasdaq looks poised for more weakness Friday as shares of

Google

(GOOG) - Get Report

and

Microsoft

(MSFT) - Get Report

were both down in after-hours trading after reporting quarterly results.

The

S&P 500

(SPX)

fell 8.16 points, or 0.7%, to 1227.04.

Big Talk Over Little Reval

While it sent tremors throughout most markets, China's move remains minuscule in scope. The People's Bank of China said the immediate result of Thursday's action would be a 2% revaluation of the yuan to 8.11 against the dollar. Further moves remain unclear.

"This is an utterly cosmetic, unbelievably small and inconsequential move that China took before

president Hu Jintao comes to the U.S.

in September," says Dennis Gartman, who writes daily on global investments in

The Gartman Letter

.

Amid mounting trade tensions between the U.S. and China over the yuan peg, which has kept Chinese exports cheap and made U.S. goods less competitive, this is simply "a gesture of goodwill," Gartman says.

According to Bank of America strategist Thomas McManus, it would take a 15% to 25% appreciation of the yuan against the dollar for U.S. importers -- such as retailers -- to cut back on Chinese imports, McManus says. By then, importers would likely "find it difficult to pass along price increases to low-end U.S. consumers who are already paying more for energy and short-term money."

Bonds and the dollar stumbled. The Chinese move, although very small in scope, fueled concerns that China would rely less on the dollar and more on other currencies to manage its currency regime. The need for fewer dollars would thus lessen the current practice of recirculating dollars by buying Treasuries.

The dollar fell as traders bought yen and the euro on the belief that Japanese and European exports would be more competitive should the yuan continue to appreciate.

The yen was the biggest gainer, rising over 2% against the dollar, while the euro added 0.2% vs. the dollar, after rising close to 1% earlier in the session.

The benchmark 10-year bond fell almost an entire basis point, while its yield rose to 4.28%.

China, it seemed, succeeded where two days of testimony by

Federal Reserve

Chairman Alan Greenspan had failed when he signaled the Fed would continue lifting short-term interest rates. Rising bond yields added to the downward pressure on stocks.

Bond traders also pondered the possibility that a substantial appreciation of the yuan would eventually raise import prices for many countries. In combination with rising production costs for businesses, this could undo the global deflationary trends that have helped keep bond yields and borrowing costs low across the world.

Commodity prices, likewise, were buoyed by the prospect that a strong yuan would allow China to purchase more of the basic materials it devours each day. Crude oil, however, fell 89 cents to $57.13 on Nymex because of improving supply fundamentals. Traders also wondered if a stronger yuan may eventually slow Chinese exports enough to slow China's economy.

The

Amex oil index

fell 1%, with the stock of oil majors slumping.

Exxon Mobil

(XOM) - Get Report

fell 1.71% and

Chevron

(CVX) - Get Report

eased 1.73%.

For Merrill Lynch market strategist Richard Bernstein, however, a yuan revaluation could provide added stimulus to China's investment sector. "It would act like a 'cents off' coupon on dollar-denominated industrial commodities," he wrote in a research note.

"Thus, a revaluation could be quite good for the commodity and energy stocks, in our view, and if the revaluation had been significant, we might have had to rethink our current underweight of materials and equal weight of energy," Bernstein wrote.

Should the yuan further appreciate against the dollar, however, the strategist says he may reconsider these underweight positions. Utilities, he adds, could also benefit given their positive link to energy prices.

Most of all, Bernstein remains bearish on the consumer discretionary sector as "ultimately, the only way to solve the trade and current account imbalances is to slow U.S. domestic consumption."

To view Aaron Task's video take on today's market, click here

.

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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