China could be about to plunge us all into a world of pain
The trade of the year has come back to haunt markets.
The Chinese yuan has weakened against the dollar at its most rapid rate since last August, when Chinese officials devalued the currency.
This move is also a throwback to a scary recent time — the turmoil at the beginning of this year after the Fed's first rate hike since going to zero in December 2008.
In January and February, the yuan's erosion against a strong dollar prompted Chinese people to move money out of the country, which spooked its stock market, which in turn spooked markets around the world.
And now, that recent history is repeating itself.
Along with more rate-hike talk, a swiftly plunging yuan is back.
What's more, the messaging out of China is just as confusing and aggressive as it was before. Again, the government is maintaining that the yuan is floating freely against a basket of currencies, as it has insisted since the end of last year.
Again, the government is throwing a tantrum anytime the foreign media talks about this issue.
And for the first time since the disaster during the winter, the Chinese stock market experienced an almost instant, eye-popping drop on Tuesday.
To fix or not to fixLast week, The Wall Street Journal published a bombshell report detailing how the government is supporting the yuan's fix against the dollar. This goes against what the Chinese government promised at the end of last year: to let the yuan float more freely against an unknown basket of currencies.
The report prompted The People's Bank of China (PBOC) to rail against foreign media's "fabricated attacks."
Then, the head of a Chinese bank and Communist Party official went on the record with Bloomberg explaining how the yuan is set every day.
That means officials can take into consideration, say, an impending US rate hike — or whatever else they like.
Federal Reserve Board Chair Janet Yellen testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on the "Semiannual Monetary Policy Report to Congress" in Capitol Hill, Washington February 11, 2016
As a result, even less so than the end of last year, Wall Street isn't taking China's public policies on the yuan at face value, which only adds even more to this deep confusion.
From HSBC's note on Bloomberg's explanation of the yuan's fixing (emphasis added):
What is and what should never beThe thing is, the yuan is weakening partly because the Chinese economy really is slowing. After the volatility at the beginning of this year, the government pumped money back into the housing market to keep things rolling. Credit growth, however, is making less of a positive impact on the economy as debt rises. The problem is that China needs productive credit, not just more credit.
This very real slowdown is evident in all kinds of data, and it's defying Wall Street's expectations with its rapid pace.
Morgan Stanley's Adam Longson and his team of analysts wrote (emphasis added):
Goldman Sachs/Gao Hua economist Song Yu is calling the calm that the yuan experienced over the past few months a "temporary sweet spot." He told Bloomberg in an interview that the government will likely instate capital-control measures to restrict outflows.
"But this is very much like a game of a cat trying to catch the rats," he said. "Whenever the government manages to block a hole through which capital leaks out, people can always dig another hole to bring the money out over time."
Think of this as a game of whack-a-mole, except that it can send global markets into a red alert and freak everyone out for weeks at a time ... so not a game at all, actually.