The devalued yuan

October 26, 2015 09:00 AM

The Chinese devaluation of the yuan on Aug. 11 from 6.20 to 6.45 was a game changer for currency markets and creates critical challenges to the forex trader. Let’s explore its effect.
The devaluation is a departure from the relatively stable range regime keeping the yuan near 6.20 and within a 2% band to a 4% weakening in two days. The Peoples Bank of China (PBOC) bought yuan on the third day to attempt to restore confidence in the stability of the currency. The idea of a market-based valuation of the yuan was undermined by the PBoC intervention. This “managed” devaluation disrupted the old order where a relatively fixed yuan/dollar rate was the enduring environment and introduced long-term uncertainty to future PBOC moves.

Now traders need to check the yuan/dollar rate each day as well as expectations of PBOC activity, because market forces will cause further devaluation. Before Aug. 11, traders were focused on the Federal Reserve and the likelihood of a September rate hike. Now the PBOC, and statements it makes will be part of the daily check list for trader scrutiny. Before Aug. 11, few knew the name of the head of PBOC Zhou Xiaochuan. People know it now.  

While the Chinese economy has long been closely monitored, the devaluation — an attempt to stimulate exports—brought a stronger emphasis to it. Behind the decision was fear that without it, Chinese growth would decline to below 7%. China’s goal to be accepted by the International Monetary Fund (IMF) as a reserve currency also is thought to be part of the devaluation decision. However, tracking Chinese economic data is not as precise as tracking the intentions of the Fed or quantifying U.S. economic data .This uncertainty in the precision of Chinese data shifts the emphasis to looking for indirect signs of slowdown or growth. These include auto sales, housing prices, electricity consumption, etc. Waiting for published official data may be too late (and not accurate). 

More important than the devaluation is increased  concern over Chinese growth expectations. The sell-off in the Shanghai Index was a sentiment response that the devaluation would not be enough to maintain confidence in the near-term economic prospects of China. Between Aug. 11 and Aug. 25, more than $5 trillion was erased from the value of global equities.

The yuan devaluation shows why currency traders need to diligently track China. While there is no formal “China Fear Index,” the nearly parabolic upward path of the Shanghai Composite Index was a classic early reversal signal that was essentially ignored by U.S. markets. This divergence ended after the shock of Aug. 11.

Traders going forward should follow key technical areas in the Shanghai Index as zones of alerts. Tracking the daily movements of the Shanghai index provides confirmation on direction for trading currency pairs that are affected by China. Checking the USD/JPY’s reaction to the Shanghai Index movements is a useful way of detecting whether global market reaction is risk-on or risk-off. The recent selloffs showed clearly that the yen acts as a safe haven. It has closely tracked the Shanghai Index and the S&P 500. 

The more difficult challenge will be to look for sentiment signals regarding confidence about China itself. Binary Options on the China A50 and CSI 300 are potential sources of sentiment and can be traded through Nadex and IG Markets. Another source is using key equities such as Alibaba (BABA). Since the devaluation, Alibaba and the Shanghai Composite Index have been closely correlated (see “Peas in a pod”). 

For the forex trader, the devaluation of the yuan creates greater emphasis on understanding how China moves global markets.

About the Author

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.