What Chinese Devaluation Means for the Market

08/17/2015 9:00 am EST

Focus: CURRENCIES

Adam Lemon, of DailyForex.com, shares his opinion as to the effect China's devaluation of the yuan may have—not just for pairs and for individual currencies—but upon the global markets themselves.

China has just devalued its currency, the yuan, by almost 4% in two successive surprising one-day moves. This included the yuan’s biggest one-day drop in over twenty years. The Chinese government was able to achieve this as it maintains enough control to effectively peg the value of the currency within a band. The reasons why China made this move are fairly obvious: its economy is facing a serious slowdown and as its economy is so export-driven and reliant upon global conditions, it entered the currency war and made its exports relatively cheaper to foreign consumers through the quick fix of devaluation.

A more interesting question with less transparent answers is, what effects will this have upon global markets? Fundamental analysts are keenly pondering the implications of the yuan’s devaluation.

This move has been seen as a signal by the Chinese government that it is moving towards letting its currency float freely. A truly freely floating yuan will add an element of instability into global markets, meaning that the prices of Chinese manufactured goods would be likely to fluctuate to a greater degree. This, in turn, could import more price instability into economies which have a great exposure to China, especially Australia and New Zealand.

Deflationary Forces

Many analysts see the overarching macro effect of the Chinese devaluation as a contribution towards deflationary forces throughout the global economy.

What would this mean for individual currencies and markets? The problem with drawing conclusions is that the chain of causation may end up having effects that are not easily predictable. The underlying themes will be a deflationary threat, harm to economic growth, and fear of a competition between nations in devaluing their respective currencies.

US Dollar

The first effect is to make the prospect of a USD rate hike in September seem extremely unlikely, in fact, the idea of a rate hike any time before 2016 now seems increasingly improbable. This has had the immediate effect of sending the USD into a fall off its recent highs, and while there may not be a long-lasting and strong trend against the USD, it is likely to lose its relative strength. The market’s focus will turn elsewhere to look for a strong currency, and there are very few candidates for this role.

NEXT PAGE: Does the Chinese Devaluation End Here?

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British Pound

The pound has—for a while now—been generally the second strongest currency after the USD and really the only other major currency where the market has been expecting a rate hike. Although the Bank of England signaled that a rate hike isn’t going to happen any time soon, the fact remains that there is bound to be some upwards speculative pressure on the pound now.

Euro

The Chinese devaluation risks becoming a serious headache for the European Central Bank, which has probably been enjoying a well-deserved August holiday to recuperate from all the recent drama and trauma. European QE was launched successfully following a major fall in the euro against the USD, the result of which has been the sprouting of some green shoots of economic recovery.

The euro has been showing some strength recently, which is natural after such a huge fall as recovery begins, but the euro is now shooting up against other currencies and this could put some deflationary and recessionary pressure on European economies. Most troublingly for the ECB, they are arguably running out of policy tools, as there is already a QE program and interest rates are practically zero. For now, an extension of QE or negative interest rates are unlikely, but if the EUR/USD currency pair breaks strongly above 1.15 we may begin to see these options considered.

Commodities

Oil and copper are likely to fall in the short-term. Although they are priced in USD, so much demand comes from China, which will effectively be buying them more cheaply in yuan terms. However, an argument could be made that China will actually be able to afford significantly greater quantities of oil, which might have the effect of stopping any further significant fall in price.

Australian Dollar

If the Chinese devaluation ends here, the Australian dollar may be expected to fall, but probably not by very much. However, the Aussie is already making 6-year lows and has fallen by more than 25% over the past three years. The RBA recently signaled a retreat from its extreme dovishness, but may be forced into turning again in the other direction. In the short-term, the RBA is likely to adopt a wait-and-see approach.

Equities

The current global bull market in equities is very mature and increasingly weak. There have been death crosses in several markets and the S&P500 Index is very close to making such a cross. Obviously there will be differences between equity markets geographically. Although it is now expected that there will be no US rate hike in the very near future, which might have been expected to prop up the equity market, the fear over the increased prospect of economic slowdown is likely to weigh more heavily. This makes a strong correction or end to bull markets in equities more probable.

By Adam Lemon, Contributor, DailyForex.com

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