Since the Aug. 11 surprise devaluation of the Chinese yuan, and the follow-on Aug. 24 “black Monday” Shanghai market sell-off, forex traders have had to be more cognizant of the impact of Chinese currency and Shanghai market movements. Chinese market sell-offs are becoming nearly routine occurrences and the prospects of further sell-offs are high in the coming year as uncertainty related to Chinese economic growth endures. The weakness in the Chinese economy continues to create market uncertainly as forecasts of Chinese GDP are trending lower. The World Bank forecast that Chinese GDP for 2016 would be at 6.7%, in contrast to 6.9% in 2015 may be optimistic. This slowdown has led to further devaluation of the yuan. China now faces the possibility that the USD/CNY pair will further weaken to the 7 -7.5 range and at those levels it will spill over to the financial and currency markets. The challenge to the forex trader is how to best trade and profit from these events. Based on market reactions to the Shanghai Composite Index sell-offs, the best currency pair to trade is USDJPY.
When the Shanghai Composite Index (SCHOMP) sells off, there is usually an immediate safe-haven response in the markets. This can be seen in the USDJPY’s price reaction. The yen strengthens as fear generates a risk aversion mood and capital goes to the yen (see “Safe haven”).
When the Shanghai Index resumes an upward direction, markets interpret it by selling yen and buying dollars. So the first trading directional decision in responding to Shanghai index sell-offs is to follow the crowd. Those momentum traders that are watching the Shanghai Index movements should be looking to sell USDJPY in the spot market. U.S. traders get the added benefit of being able to trade this co-movement in the evening. The opportunity to play the Chinese market continues into the next morning when the U.S. markets open. Herein the co-movements between the Shanghai Index, the S&P 500 and USDJPY require a careful watch on the price action. The USDJPY tends to move in a similar direction to the S&P, reflecting a risk aversion spillover from the previous night’s China market action.
Beyond using a momentum trading tactic, an alternative trading response to a sudden and unexpected weakening of the USDJPY in reaction to the Shanghai sell-off would be to wait for new lows to be established and then play a Fibonacci bounce-back. If the price action goes beyond the 50% Fibonacci retracement level, the retracement forces are likely to continue recovery. In a sense, trading the Shanghai Index and yuan weakness follows a classical reaction-diffusion model. The initial sell-off takes the markets by surprise, and then the diffusion of the information leads to set ups for a bounce-back.
Beyond trading the USDJPY, traders also should consider looking closely at the Mexican peso. Like the yen it often correlates with the Shanghai Index. A weaker Chinese yuan makes Mexican exports less competitive. If the yuan continues to weaken and starts probing the 7 to 7.5 price range, there will be huge pressure on the Mexican central bank to weaken the peso.
It is hard to access the Chinese market directly but there are many proxies you can use to take advantage of the current volatility surrounding China.