Why Does Yuan Devaluation Hurt Chinese Stock Markets?

Talking Points:

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Sentiment trends continued to drive currency market price action in overnight trade. Investors’ mood brightened after two days of aggressive selling after China suspended circuit-breakers that shut off stock market trade after just 14 minutes of activity yesterday and set the daily Yuan fix a bit higher. The risk-geared Australian, Canadian and New Zealand Dollars outperformed while the safety-linked Japanese Yen proved weakest on the session.

Markets’ response to this week’s CNY devaluation has been somewhat confounding. After all, weakening the currency is a form of monetary stimulus, which might have been expected to boost risk appetite. Last year’s introduction of the ECB’s QE program is just the latest example: the effort was unmistakably negative for the Euro but strongly supportive for equity market sentiment (as embodied by Germany’s DAX index).

Looking at a Bloomberg index of Chinese monetary conditions and China’s benchmark CSI 300 stock index, a significant inverse relationship between easing and share prices appears to have emerged. The existence of this seemingly counter-intuitive link may reflect the peculiar nature of participants in Chinese stock markets. Individuals rather than institutions predominate by a staggering factor of nearly 350. These are far from long-term investors: average holding periods fell to just one week in mid-2015, according to research from the Bank of Communications (as cited in the Wall Street Journal).

This implies an interesting narrative. Weakening the Yuan erodes individuals’ purchasing power of imported goods and services. Wages’ adjustment to such changes is notoriously slow. This means devaluation may have forced punters in Chinese stock markets to divert “play money” out of stock trading accounts and toward budgeting for more mundane expenses.

Looking ahead, December’s US Employment report is in focus. An increase of 200,000 in nonfarm payrolls is expected, keeping the jobless rate unchanged at the post-recession low of 5 percent. Perhaps most significantly, the year-on-year growth rate in average hourly earnings is seen rising to 2.7 percent, the highest in almost six years.

Such a result may inspire speculation that the Fed meant business when it forecast four 25bps rate hikes in 2016 last month, clashing with investors’ priced-in outlook calling for just two. This may prompt a hawkish shift in the market outlook, boosting the US Dollar. The prospect of more aggressive tightening may also rekindle risk aversion, delivering outsized losses for higher-yielding FX like the Aussie and the Kiwi.

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