Simon Derrick, BNY Mellon’s Chief Currency Strategist, examines some issues to watch in 2017.
If 2016 proved anything it was that event risk seemed to be back for the financial markets. 2017 looks to be just as lively. Here are some thoughts on a few issues we suspect may be on the radar.
• The incoming administration and US dollar strength:
Early indications from President-elect Trump and his key appointees suggest a policy mix that could sustain USD bullishness. While a steepening of the US yield curve isn’t automatically USD bullish, what most certainly has been supportive of a stronger USD has been the widening out of key international yield gaps at the longer end. Read more
• The impact on China:
A strong US dollar could provide China with significant policy challenges in 2017. While it certainly doesn’t follow that we are about to see a repeat of the type of market volatility that emerged at the end of 2015 and the beginning of 2016, the scale of the declines in China’s FX reserves raises a couple of interesting points that could prove important in 2017. If China’s FX reserves continue to decline in value both as a result of active intervention in the local market and changes in asset values (with bond price moves being singled out by the regulator) and if US yields continue to rise along with the USD, then it could well be that the trend towards reduced holdings of US Treasury securities continues in 2017. Read more
• US currency policy:
Irrespective of what China may or may not do, the issue of USD strength could become a domestic political issue in 2017 should it persist. This would certainly not be the first time that this has occurred in the modern era. Read more
• Italian political uncertainty has not gone away:
While most eyes are now on the Dutch general election, the French presidential election and the next election of Bundestag members in the second half of the year, there may well be a general election in Italy at some point in the first half of 2017. While the polls continue to indicate that the Five Star Movement would win control of the Chamber of Deputies if a general election occurs in 2017, in the absence of any reform of the electoral law with respect to the upper house they would need to abandon their opposition to forming coalitions in order to gain control. Even if they were to form a bloc with other euro-sceptic parties, such a coalition might prove highly unstable. Nevertheless, given the Five Star Movement’s unambiguously anti EUR stance and the global political upsets of the past 12 months, investors might decide that discretion is the better part of valour. Read more
A few recurrent themes have emerged in President-elect Trump’s pre-and post-election comments and in comments from certain key appointees. While it is impossible to say whether or not any of these themes will result in tangible policy shifts, such comments should not be dismissed or ignored. These themes are:
1. Infrastructure spending & tax cuts appear to be top agenda items.1,2.
2. The broad direction of comments from president-elect Trump, Steven Mnuchin & David Malpass indicate a desire to extend the maturities on US government debt.3,4,5
3. One of the most consistent themes over the past 12 months has been President-elect Trump calling China a currency manipulator. That hasn’t changed since the election.6,7,8
4. The incoming administration seems lukewarm towards the Fed.9,10
The collective impact of these key themes (particularly 1 & 2) has been a sharp steepening of the yield curve in the US (similar in pace to the early stages of the “taper tantrum” in the summer of 2013) over the past month. While a steepening of the US yield curve isn’t automatically USD bullish (as can be seen by comparing shifts in the 10-year/2-year yield gap over the past quarter of a century with the performance of the USD index), what most certainly has been supportive of a stronger USD has been the widening out of key international yield gaps at the longer end. As of December 7,the yield gap between 10-year US and the equivalent benchmark German government paper had widened out by close to 35 bp since the election, taking it to 202.5 bp, almost the widest the gap has been in at least a quarter of a century. Similarly, the US/UK spread had moved back out to where it was in late August (just below 100 bp), levels previously seen in 2000. While other moves may have been to less dramatic levels when looked at in historical terms (the US/Japan spread is only back to where it was in 2010), the absolute moves have been sharp (the US/Japan spread moved out by 47 bp).
A rising USD has, in turn, fed through into mounting pressure on the CNY (the spread between spot USD/CNY and the 1 year NDF on December 7, stood at roughly the same levels that it did in late November of last year). These pressures began to re-emerge in October as the likelihood of a December rate hike by the Federal Reserve began to filter through. The first sign of this was the publication on November 7 of the October FX reserve numbers by the People’s Bank of China (“PBOC”). These numbers showed that reserves fell in value by USD 45.7 bn in October taking them down to USD 3.121 tn, the lowest since March 2011. This stood in contrast to the more modest swings seen in the USD value of China's FX reserves over the previous seven months (ranging between USD 27 bn down in May and USD 13 bn up in June). While the argument could be made that this decline was connected to valuation effects (the USD index was up 3.1% m/m in October), it is meaningful that the decline seen was significantly larger than that seen in May (USD 27.9 bn) when the USD index rallied by a similar amount.
By late November a number of reports by Reuters indicated that state-owned Chinese banks had been actively selling USDs in the onshore spot market11. Moreover, the mood music out of China began to change. On Friday, November 26 the WSJ published a story12 saying that the State Council would soon announce a series of measures that would subject many overseas deals to stricter regulatory oversight. This was followed the next day by a story in Caixin that the PBOC was considering including cross-border CNY business into its assessment of macro-prudential risks in the country's financial system. The magazine then quoted an unnamed banker as saying this would force banks to "do more incoming CNY business, and less CNY outflow activities."13
That Sunday the PBOC vice governor Yi Gang said on state TV: "(China's) international balance of payments are basically stable, the merchandise trade surplus remains relatively large, and the CNY has the conditions to remain basically stable within a reasonable range in the future." He added: "The movement of the USD going forward is uncertain, and we can't rule out the possibility that changing market expectations will cause some decline in the USD." 14
The following Monday Wang Zhenying, head of the Statistics and Research Department of the PBOC's Shanghai Head Office, told Reuters: "At the moment, the fall in the CNY's exchange rate is shaping market expectations. Depreciation triggers capital flight, and capital flight exerts even bigger pressure on the CNY. Therefore, it's necessary to break this feedback loop... for example, by slowing capital outflows."15
Confirmation that pressures had been mounting over the past month came with the publication of China's FX reserve data for November. The data showed a decline in the USD value of USD 69.05 bn over the course of the month. While not quite at the level of November 2015's USD 87.2 bn decline it was still the most significant drop since January of 2016 (USD 99.46 bn) and the eighth largest monthly decline ever. Indeed, such was the scale of the drop that the State Administration of Foreign Exchange posted a notice on its website saying that the PBOC had to provide capital from its foreign exchange reserves to the market, in order to maintain a supply and demand balance in foreign exchange reserves. It also noted that fluctuations in asset values and the depreciation of a range of currencies against the USD in the wake of the US election also contributed to the decline (Reuters). To put this into context though it is worth noting that the month-on-month rise in the USD index (3.16%) was not much more than that seen in October (3.12%) or May (3.01%) and slightly less than that seen in November of last year (3.39%) as the market prepared for the December rate hike by the Fed.
While it does not follow that we are about to see a repeat of the type of market volatility that emerged at the end of last year and the beginning of this year, the scale of the declines in China’s FX reserves raises a couple of interesting points that could prove important in 2017. The first point relates to the observation that since the 3rd plenum in November 2013 the net holdings of US Treasury securities by mainland Chinese investors have fallen by 12% (USD 159 bn) and the pace of this selling picked up in Q3. The most recent Treasury International Capital System (“TICS”) data (http://ticdata.treasury.gov/Publish/mfh.txt) show the holdings of Treasury securities attributed to mainland China fell by USD 83.8 bn (about a 6.7% reduction in the net position) between the end of June and the end of September. If China’s FX reserves continue to decline in value both as a result of active intervention in the local market and changes in asset values (with bond price moves being singled out by the regulator), and if US yields continue to rise along with the USD then it could well be that the trend towards reduced holdings of US Treasury securities continues in 2017.
The second point follows on from the possibility that China might be called a currency manipulator by the incoming administration in the US. It should, of course, be noted that this is hardly the first time that an incoming administration has highlighted China as a currency manipulator. Back at the start of 2009, the new Treasury Secretary Tim Geithner wrote three times to a senate finance committee that "President Obama, backed by the conclusions of a broad range of economists, believes that China is manipulating its currency"16.
It could therefore prove to be the case that the incoming administration follows a similar path to that of the Obama presidency and quietly lets the accusations of manipulation fall by the wayside. However, it is also possible (given how consistent a theme Chinese currency manipulation proved to be in the election campaign) that President-elect Trump follows through with his promise to direct his Secretary of the Treasury to label China a currency manipulator.7
Were this to be the case and China is labelled a currency manipulator for the first time since 1994, it would trigger a process for the president to enter into discussions with China and seek potential penalties.17
Irrespective of the merits of the assertion that China is manipulating its currency (it should be remembered that China’s main activities over the past two and a half years have been to prevent the CNY from weakening rather than strengthening), it would be understandable if a US move towards labelling China as a currency manipulator made China question its current policy. Given this, it is worth noting the recent comments from Yu Yongding, a former academic member of the PBOC's monetary policy committee (between 2004 and 2006) and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.
Over the course of this year Professor Yu has written and spoken on currency matters on a number of occasions. In an article published at the start of February on the World Economic Forum website18 he addressed the question of how the PBOC should deal with the growing depreciation pressures on the CNY. He argued: "In my opinion, the PBOC should reinforce the Chinese government's market-oriented reform plans and allow the CNY to float. China is still running a large current-account surplus and a long-term capital-account surplus, and it has not fully liberalized its capital account; so the chances are good that the CNY would not fall too far or for too long."
The pressures that were mounting on the CNY in late January did fade in subsequent months (as highlighted both by the stabilisation in the nation's FX reserves and a rapid narrowing in the spread between CNH and CNY) thanks to the Federal Open Market Committee’s (“FOMC”) move to a more dovish stance. However, Professor Yu has again been speaking on currency issues in recent weeks19. Writing in the Shanghai Securities News he argued that the mechanism adopted by the PBOC to set the CNY's midpoint rate does not allow for "true two-way volatility" in the exchange rate, and had hurt foreign exchange reserves as a result. He stated: "Preventing the CNY from reaching market equilibrium is objectively a rejection of raising the cost of capital flight. It even encourages capital flight." He also noted: "We have capital controls as the last line of defence. It is not necessary for us to worry too much about the short-term and volatile depreciation in the CNY." Comments quoted by the South China Morning Post were equally direct20.
Having noted that China has spent more than USD 800 bn over the past two years supporting the CNY, he highlighted that "in comparison, during the Asian financial crisis, the funds used by multiple countries to support local currencies was only US$ 200 billion." He then noted that "The devaluation expectation of the CNY will not ease if the government's intervention slows down." The message was clear: float the CNY while using capital account controls to "appropriately interfere with the foreign exchange market."
It looks unlikely that the PBOC is set to make such a radical shift in policy at any point in the near future. Indeed, a Reuters story published on November 1821 made it clear that the bank was ready to act if the pace of CNY depreciation picked up towards year end. It is also worth recalling that China has previously demonstrated a marked reluctance to shift policy in the face of what it perceives as external pressure22.
Nevertheless, it's worth noting that the broad mood music continues to indicate that China remains committed to liberalising the exchange rate23.
Given the prescience of Professor Yu's comments over the past decade on currency matters, this looks like a story worth monitoring over the next twelve months.
Irrespective of what China may or may not do, the issue of USD strength could become a domestic political issue in 2017 should it persist. This would certainly not be the first time that this has occurred in the modern era. Probably the most notable event to come out of such pressures in the past was the signing of the Plaza Accord on September 22, 1985 by the Ministers of Finance and Central Bank Governors of France, Germany, Japan, the United Kingdom, and the United States. In it they agreed that "…exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. “They indicated at the time that policy actions must be implemented and reinforced in order to improve fundamentals further, and that in view of present and prospective changes, some further orderly appreciation of the main non-USD currencies against the USD was desirable."24
Although it is debatable whether or not the weakness of the JPY against the USD in the run up to the accord was truly due to a deliberate attempt by Japan to manipulate its currency lower (1979 to 1987 was, after all, the era of the Volker Fed), this had not prevented an increasingly vocal lobby group in the US from asking for protection against foreign competition25. By 1985 the political pressure had grown sufficiently for Congress to begin thinking about trade restrictions. In the face of this the White House was pressured into negotiating the accord despite its own free-market instincts (presumably seeing it as the lesser of two evils).
This was not the end of attempts by the US to get the USD to weaken against the JPY. Most notably the very early months of President Clinton's first term in office saw what looked a lot like an explicit attempt to take the JPY higher. Rumours had already circulated on election night in November 1992 that the new administration would target the exchange rate. However, investors then chose to ignore these early hints about the direction of policy under the new administration, keeping the USD gently bid through until mid-January 1993.
The campaign itself kicked off in earnest on February 19, 1993 when Treasury Secretary Lloyd Bentsen (at an event at the National Press Club in Washington): Emphatically called for a stronger yen.26
Two months later President Clinton was asked (following a meeting with Prime Minister Kiichi Miyazawa) why he expected trade relations with Japan to improve and the trade deficit to narrow. He noted: "...there are three or four things working today which may give us more results: Number one, the appreciation of the Japanese yen."27
Whether or not the Clinton administration was targeting a stronger JPY was, in retrospect, irrelevant. What did matter was that investors believed it was (between February and August of 1993 the USD fell by around 20% against the JPY).
Why does this matter now? Since early November the USD has staged one of its most aggressive rallies against the JPY since the spring of 1995. While the rise in US yields since the presidential election has likely been the most significant factor in driving this move it must be noted that the Bank of Japan (“BOJ”) policy has played its part as well thanks to the introduction of "QQE with yield curve control."28
The first practical example of this policy framework at work came in mid-November when the BOJ stepped into the market by offering to buy unlimited amounts of 5-year JGB notes at - 4 bp and 2-year paper at -9bp. There was little ambiguity as to why they had done this, as Governor Haruhiko told the upper house financial affairs committee later the same day: "Moves in Treasuries do have an impact on Japanese bond yields. That does not mean we have to automatically accept gains in Japanese bond yields every time Treasury yields rise."29
While that move was in line with the framework outlined in their September meeting, it was noticeable that it came after a very brief period during which key yield gaps had actually narrowed while the USD had dipped back down to JPY 108.51. This perhaps suggested that the authorities were keen to avoid the recent USD rally stalling. If so then they certainly succeeded.
With this in mind it is also worth recalling president-elect Donald Trump's previous comments on the issue of currency manipulation. In particular, while there has been plenty of focus on what he has had to say about Chinese policy, it should be noted that he has also discussed Japanese policy. Speaking in North Charleston at the start of the year30 he stated: "Japan, the same thing. They are devaluing — it's so impossible for — you look at Caterpillar Tractor and what's happening with Caterpillar and Kamatsu (ph). Kamatsu (ph) is a tractor company in Japan. Friends of mine are ordering Kamatsu (ph) tractors now because they've de-valued the yen to such an extent that you can't buy a Caterpillar tractor. And we're letting them get away with it and we can't let them get away with it."
Should the USD make substantial gains from here (particularly against the JPY), it will be interesting to see how president-elect Trump responds given his previous comment.
While most eyes are now on the Dutch general election (which must take place no later than March 15), the French presidential election in May and the next election of Bundestag members in H2, these may well be joined by a general election in Italy at some point in the first half of the year.
Following the resounding vote against electoral reform in the December 4 referendum, the Italian Prime Minister, Matteo Renzi, rapidly announced his intention to resign and made clear he will not be accepting a new mandate31 .
Although President Sergio Mattarella reportedly wants parliament to draft a new electoral law before any election is held32, talk has risen rapidly of an election in the earlier part of next year with calls coming from within the Democratic party and from outside as well.
Were there to be an election held in the near future then the polls continue to indicate that the Five Star Movement would win control of the Chamber of Deputies, the lower house of Italian parliament33. However, in the absence of any reform of the electoral law with respect to the upper house (the upper house is currently elected with a proportional system) the lower house would need to abandon their opposition to forming coalitions34 if they wish to gain control. Even if they were to form a bloc with other euro-sceptic parties, the risk would be that such a coalition might prove highly unstable. Nevertheless, given the Five Star Movement’s unambiguously anti EUR stance35 and the global political upsets of the past 12 months, investors might decide that discretion is the better part of valour.
1Vox.com article on 9 November 2016 titled "Donald Trump wins 2016 presidential election: victory speech, full transcript"
2Forbes article on 9 November 2016 titled "A Tax Cut Is On The Way In The US, But The Devil Will Be In Trump's Details"
3CNN politics article on 10 May 2016 titled "Trump: US will never default 'because you print the money'"
4The Wall Street Journal article on 20 November 2016 titled "What Will Donald Trump Do on Economic Policy? Here’s a Top Adviser’s View"
5CNBC politics article on 30 November 2016 titled "Trump picks for Treasury and Commerce want to boost economy through tax and trade reform"
6The Wall Street Journal article on 9 November 2016 titled "Ending China’s Currency Manipulation"
7NPR article on 9 November 2016 titled "Here Is What Donald Trump Wants To Do In His First 100 Days"
8Bloomberg article on 4 November 2016 titled "Trump Takes On China in Tweets on Currency, South China Sea"
9Fortune article on 20 April 2016 titled "Donald Trump Likes Low Interest Rates But Says He’d Replace Yellen
10Business Insider UK article on 22 November 2016 titled "Trump may be ready to make a big impact at the Federal Reserve"
11Reuters article on 27 November 2016 titled "China state-owned banks sell dollars in onshore market, yuan firms- traders"
12The Wall Street Journal article on 26 November 2016 titled "China Issuing ‘Strict Controls’ on Overseas Investment"
13Reuters article on 26 November 2016 titled "China may look at banks' cross-border yuan business in risk assessments: Caixin
14Reuters article on 27 November 2016 titled "Chinese yuan still a strong currency, should stabilize: central banker"
15CNBC article on 28 November 2016 titled "RPT-INTERVIEW-Senior PBOC researcher: Must break "feedback loop" behind yuan falls"
16The Telegraph article on 23 January 2009 titled "Timothy Geithner currency 'manipulation' accusation angers China"
17Bloomberg article on 9 November 2016 titled "Trump to Brand China Currency Manipulator, Ex-Treasury Aide Says"
18World Economic Forum article on 1 February 2016 titled "How can China stabilize its currency?"
19Reuters article on 22 November 2016 titled "New yuan fix 'encourages capital flight' from China: ex-PBOC policymaker"
20South China Morning Post article 17 November 2016 titled "Yuan will slide by 5 per cent at most in 2017, says top economist"
21Reuters article on 18 November 2016 titled "China ready to slow yuan descent, worried about capital outflows - sources"
22China View article on 27 January 2005 titled "Economist: China loses faith in dollar"
23CNBC article on 30 October 2016 titled "Central banker says China will maintain exchange rate reform- Securities Times"
24G8 article on 22 September 1985 Announcement the Ministers of Finance and Central Bank Governors of France, Germany, Japan, the United Kingdom, and the United States (Plaza Accord)"
25National Bureau of Economic Research PDF published on January 1994 titled "National Bureau of Economic Research"
26The New York Times article on 20 February 1993 titled "Currency Markets; Bentsen Call for Strong Yen Sends Dollar to a New Low"
27Institute for International Economics PDF published on 25 October 1994 titled "Clinton's Dollar Policy and The Effectiveness of Foreign Exchange Intervention"
28Bank of Japan article titled Outline of Monetary Policy
29Reuters article on 17 November 2016 titled "BOJ fights off spike in JGB yields in test of revamped bond-purchase plan"
30The New York Times article on 15 January 2016 titled "Transcript of Republican Presidential Debate"
31Bloomberg article on 4 December 2016 titled "Renzi Resigns as Italy Votes ‘No’"
32Reuters article on 6 December 2016 titled "Italian president pushes for new voting law before election"
33Wikipedia article titled "Opinion polling for the next Italian general election"
34Reuters article on 18 November 2016 titled "Italy's maverick 5-Star Movement faces difficult path to power after referendum"
35NewStatement article on 4 August 2016 titled "A guide to Europe’s key eurosceptic parties, and how successful they are"
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