A Trump tantrum....or a China one?

As profit-taking pauses go, yesterday was extremely modest in the grand scheme of things.  Whether this speaks to a market that is not yet fully positioned or one that is full of hubris remains to be seen, but either way it would appear to be ripe for a deeper shakeout if the environment of the last several years were to hold.  The qualifier in the previous sentence is an important one; as Macro Man has discussed over the last week, the single most important question for macro traders is not any specific of Trump's agenda, but whether the fundamental nature of the market has changed.

The question will receive its sternest test today with Yellen's testimony.  Assuming that she stays on message and doesn't attempt to predict or front-run fiscal policy (the likelihood of the latter being quite remote), it will be interesting to observe how the market reacts.   Macro Man has lost count of the number of times over the last few years when Yellen has been dovish and the greens have rallied a dozen or more ticks; if such an outcome were to eventuate today, it would raise the risk that the last week or so has been little more than a "Trump tantrum" in fixed income and the dollar within a trading climate that's still business as usual.

It certainly feels like this time is different, but then again it often does at the top.   What concerns Macro Man is this.  Having taken virtually all of his post-election risk off, he knows exactly what he wants to do in the event of a deeper correction or retracement.  Less obvious, however, is what to do if the market steamrolls over any dovish rhetoric that Yellen chooses to deliver and keeps on truckin'.  As Mike Tyson famously observed, everybody has a plan until they get punched in the mouth.

An obvious port of call in the event that the market keeps going would be to find those instruments that have lagged and look for a catch-up trade.   In the FX market, for example, if we look at current dollar levels against a range of currencies versus the extremes of the past year or two, we see a wide dispersion of current drawdowns.  While such an analysis really should be vol-adjusted, you don't need a z-score table to see that the USD is much further from its peak against the yen than against the euro.

     
The chart excludes cable, as sterling is obviously being driven by factors other than what's going on with the dollar.

One obvious pair at an extreme is USD/CNH, which highlights an important risk that could emerge later (or sooner) down the line.  Given the nature of the Chinese currency regime, rampant USD strength applies a lot of pressure to the mechanism.  Essentially, the authorities have three options:

1) Allow the RMB to strengthen versus the basket.    This would entail keeping the CNY essentially flat against the USD, thereby implying yuan strength against everything else as the dollar appreciates.  While bad for China's overall trade account, it would mitigate capital account pressures.

2) Keep the basket basically stable.   The implication here is that whatever the USD does against the rest of the world, it will also do against the RMB.     This is broadly neutral for China's overall trade account but runs the risk of engendering capital flight if the public's perception of  RMB weakness becomes too acute.

3) Say "damn the torpedoes" and weaken the RMB versus the basket.   While China has done this on occasion, particularly last August and early this year, it becomes problematic when USD strength becomes too acute.  The reason is that the mathematics of the basket mean that the RMB has to weaken more against the USD than other currencies for it to weaken against the basket overall; obviously, that can run into serious difficulties regarding capital flight and financial stability.

As Macro Man has observed several time in recent weeks, since July the authorities have opted for option 2 above.

The issue with this is that the authorities are essentially outsourcing the setting of the USD/CNY rate to the market.  While this has ostensibly what everyone's been asking for for years, it's not really; there's still a currency peg, it's just to a different target (i.e., the basket.)    What it does mean is that the higher the dollar goes, the stronger the upside pressure on USD/CNY and CNH...and, presumably, the greater the capital flight and strain on PBOC's reserves.  While they may not be in dire straits for the time being, the market can and will extrapolate; the FX reserve data for November will be of paramount importance.

The alternative, meanwhile, is to allow the currency to strengthen on a trade weighted basis by keeping the peg steady/jamming short rates higher/selling USD hard to screw RMB shorts.   This, too, has negative consequences for both markets and the real economy.

Either way, it's hard to shake the notion that if the "Trump revolution" is real and not simply a tantrum, Chinese markets will get pushed, perhaps to the breaking point...and that's before anyone's pointed a finger and accused them of being currency manipulators.