FX - US Dollar to Rise on Chinese Currency Reform Despite Initial Losses

The US Dollar is likely to appreciate as China moves to reform its famously rigid exchange rate regime toward a looser posture despite a kneejerk decline after the central bank’s initial announcement of the policy shift.

Key Overnight Developments

• US Dollar Sold as China Reveals Plans to Loosen Exchange Rate Policy
• UK House Prices Rose Least in Three Months in June, Says Rightmove
• Australian Vehicle Sales Slump as Higher Interest Rates Trim Demand

Critical Levels



The Euro and the British Pound rose against the US Dollar in overnight trade, adding 0.3 and 0.4 percent respectively as traders broadly sold the greenback after China announced a move toward a less rigid exchange rate policy (see below). We remain flat EURUSD and GBPUSD.

Asia Session Highlights



The US Dollar came under intense selling pressure in Asian trade after the People’s Bank of China said it will proceed with reform of China’s currency regime “enhance [Yuan] exchange rate flexibility.” The PBOC cautioned that “the basis for large-scale appreciation…does not exist,” seemingly taking possibility of a one-off revaluation off the table, adding that “the exchange rate floating bands will remain the same.” The greenback recovered some the ground lost in the initial knee-jerk selloff after the central bank kept its Yuan reference rate unchanged at 6.83 to the US unit, the same level that has prevailed since mid-2008 when Beijing paused the process of gradually loosening exchange-rate controls initially introduced in 2005 as policymakers scrambled to stabilize the export-dependent economy amid the global credit crunch and subsequent recession.

UK House Prices added 0.3 percent in June according to a survey from Rightmove Plc, an online listing of for-sale properties, marking the smallest increase in three months. Rightmove commercial director Miles Shipside said prices may fall in the second half of the year, amounting to no change over the whole of 2010, as a scarcity of mortgages and the possibility that the government will raise the capital-gains tax weighs on demand for new property.

Australian New Motor Vehicle Sales slumped 3.2 percent in May, marking the largest decline in four months. Sales of passenger vehicles fell 3.8 percent – the first decline since December 2009 and the largest one in 14 months – as higher financing costs in the wake of the central bank’s series of interest rate hikes weighed on demand.

Euro Session: What to Expect



With nothing of note on the economic calendar, China’s announcement on exchange rate policy should dominate currency markets’ attention in European trade. We suspect the move’s larger implications may be substantially more limited than initial volatility suggests. Building fears of asset bubbles and runaway inflation have had traders convinced for some months that Beijing will step up efforts to rein in economic growth. Allowing an appreciation of the currency achieves just that, amounting to a de-facto interest rate hike, so it seems likely that little has actually changed in the markets’ consensus assessment of the Chinese policy landscape. The timing of the announcement is also suspect, coming just ahead of next weekend’s G20 summit in Toronto and hinting that it may amount to little more than rhetoric designed to mute global criticism of the peg’s role in contributing to global economic imbalances and shift attention elsewhere.

On balance, the markets’ near-term reaction should prove supportive for risk appetite as traders take the move to mean that the world’s largest exporter is confident that the prospects for global demand are substantially robust to afford a direct (if gradual) reduction in the competitive advantage afforded by a cheap currency. The announcement also cools building tensions between China and the US and reduces the likelihood of a trade war, a clearly positive development. Indeed, shares rose aggressively in Asian trade and more of the same is likely going forward with US equity index futures adding close to 0.8 percent ahead of the opening bell in Europe, hinting the safety-linked US Dollar and Japanese Yen will remain on the defensive against most major currencies.

In the medium term however, the outcome seems to actually bode well for the greenback as well as the Japanese unit as traders size up the prospects for the global economic recovery absent significant contributions from China and the EU – the world’s foremost and third-largest economies respectively – as the former willfully hits the breaks while the latter folds under the weight of a hefty debt burden. Taken against the background of a Japanese economy struggling with deflation and lackluster performance in the US, this amounts to the strong possibility of a broad-based slowdown, an outcome that translates into losses for the spectrum of risky assets to the benefit of safety-linked and funding currencies.

Longer term, if China’s reformed exchange rate policy puts “emphasis [on reflecting] market supply and demand” as well as “further enables the market to play a fundamental role in resource allocation” as the central bank suggested, the implied lifting of (at least some) restrictions on cross-border capital flows will likely translate into an influx of foreign investors into Chinese assets. As with robust foreign demand for Chinese goods, this is likely to swell China’s foreign currency reserves, which ought to benefit the US Dollar given the lack of a viable alternative in the aftermath of the EU sovereign debt debacle. Furthermore, more flexible capital controls will also unleash Chinese investors’ pent up demand for foreign assets, much of which is likely to flow into US markets by virtue of their unparalleled sophistication and liquidity, thereby further boosting the greenback.

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