China Indifference to Yuan Slide Puts Emerging Markets in Flight

(Bloomberg) -- It's not the yuan's break through 7 per dollar itself, or indeed the magnitude of the currency's move today, that's gotten so many people worried. Rather, it's what it says about China's approach to the trade war. Having previously defended the yuan at 7 and indicated it wouldn't “weaponize” the currency, something has clearly changed in the minds of the Chinese authorities.

Pandora's Box

If this is a shot across the U.S. bows and the yuan stabilizes tomorrow, then some calm will return to an emerging-market universe in the throes of an August horror show. But it will be an uneasy calm. Much worse would be evidence that the People's Bank has decided a steadily weakening currency is the way to fight the trade war, a prospect that opens a Pandora's box of negatives for a market still coming to terms with last week's “hawkish cut” from the Federal Reserve. Currency wars can't be ruled out now, as Martin Malone, chief economic adviser at Alphabook, said in a Bloomberg Television interview today.

Carry on Carry?

There's a fascinating caveat to that argument, however, and it centers on the degree to which central banks in emerging markets will remain inclined to follow in the Fed's rate-cutting footsteps. India and the Philippines are among those countries whose policy makers are forecast to lower rates this week, and although there's little sign traders expect their central banks to step back from easing at this stage, it does weaken the case for cuts that would remove an element of support for their currencies. It's a notion explored by Bloomberg's Michelle Jamrisko and Yumi Teso in an article today. And that may preserve some of the carry that's become such a comfort for risk markets this year.

Fed Factor

The other imponderable is of course that the very nervousness this injects into a market already fearful of slowing growth and the deepening trade dispute prompts the Fed into a fresh dovish tilt. And guess what. A total of four Fed rate cuts are now priced in by the end of 2020, compared with little more than three that were expected in the immediate aftermath of Powell's comments last Wednesday.

Rupee Worry

As for today's price action, only the South Korean won weakened more than the Chinese currency, losing 1.4% against the offshore yuan's 1.3% retreat. The Mexican peso and South African rand were also having a bad day. The rupee was among the biggest losers too, no doubt additionally hurt by worries over India's decision to revoke the special constitutional status of Kashmir, a move likely to exacerbate tension with neighboring Pakistan.

Worst Since 2015

It was the classic sea of red across equity markets. MSCI Inc.'s emerging-market stock gauge fell 1.9% back to its January low. It was the index's ninth straight decline, making it the longest losing streak since 2015. In a mirror image of the currency markets, South Korea's Kospi index dropped the most, falling 2.6%, while the Shanghai Composite declined 1.6%. Meanwhile, yield spreads on emerging-market sovereign bonds widened a whopping average of 11 basis points versus Treasuries.

Ruble Surprise

There was one currency that survived today's selloff. The Russian ruble rallied 0.6% on apparent relief that U.S. sanctions weren't more draconian. It may add to the Teflon-like character that the ruble has taken on, considering its near all-conquering 7.3% advance versus the dollar this year. A word of warning though for those who pay attention to history: the ruble has weakened in 10 of the past 12 years during August and it's already more than 2% lower this month.

To contact the reporter on this story: Justin Carrigan in Dubai at jcarrigan@bloomberg.net

To contact the editors responsible for this story: Justin Carrigan at jcarrigan@bloomberg.net, Robert Brand

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