Martket Update for February 28, 2014

We’ve been keeping a close eye on China this week after recent speculation of property price cuts and banks halting lending to the property sector. This came along with the devaluation in the Chinese yuan, which continued into this week. Heading into Friday, it looked as though the trend is losing steam. The Chinese stock market rallied on Friday, but this came after a sell-off early and a plunge in the yuan.  The yuan fell as low as 6.18 to the U.S. dollar today, down from 6.04 at the end of January.

The drop in the yuan would not be new worthy if it were any other currency. In this case, the government tightly controls its value and has guided it upwards for several years. This is partially done for political reasons, such as quieting politicians in the U.S. who would like to put tariffs on Chinese imports. It is also done for confidence reasons. There were times when traders tried pushing the yuan lower, but the central bank reacted by raising its value and forcing it higher.  The yuan is only allowed to fluctuate 1 percent each day from the fixed price though there are also rumors indicating the trading band will widen to 2 percent.

Over the past few years, Chinese officials been adamant the yuan is fairly valued. The reality is if China had a floating currency, it would have weakened in 2013 along with other emerging market currencies, instead of rising to a multi-year high versus the U.S. dollar.

So why is the world concerned about a small drop in the Chinese currency? The answer lies in China’s size and investor assumptions. Taking the latter first, there are likely hundreds of billions of dollars bet on Chinese currency appreciation. Businesses and financial institutions alike expect a stronger yuan. When everyone is on one side of the trade, a small change in value in the wrong direction can lead to huge and widespread losses.

More importantly, the value of the yuan greatly affects emerging markets that compete with China. One big reason why there wasn’t an emerging market currency crisis in 2013, even though there were some big losses in the Indian rupee and Indonesian rupiah, was because the Chinese yuan was stable. If the yuan begins to depreciate, this will put pressure on other emerging markets.

On the bright side, odds are the selling is close to finished, assuming the Chinese central bank is behind the move (the popular opinion at the moment). That portends a relief rally next week as Chinese investors breathe a sigh of relief. With U.S. economic data solid and more indexes pushing to new all-time highs this week, it will be a good one for the bulls. If the yuan selling isn’t over, no amount of good economic data will be able to stop the financial market volatility that erupts.

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