How to play a topsy-turvy currency and commodity market

The renminbi (Chinese yuan, or CNY) hit a record against the US dollar (USD) on 26 October 2012. The USD/CNY rate closed at CNY 1.2380 on Friday, an all-time high for the yuan. Currency markets are expecting the CNY to rise further against the USD as traders unwind long USD positions built on expectations of a deterioration in China’s economy.

The fact that China’s economy has deteriorated with GDP growth falling for the seventh straight quarter in the third quarter of 2012 has not deterred the yuan from appreciating to record highs. China’s third quarter 2012 GDP growth came in at 7.4 percent, the lowest level seen since the first quarter of 2009 when the economy grew at 6.2 percent. The sharp fall in China’s equity markets too has not deterred yuan bulls. The Shanghai Composite Index is down 64 percent since October 2007 and has lost 28 percent since October 2011. So why is the yuan rallying as if there is no tomorrow?

The yuan is a managed currency and China’s central bank, the PBOC (People’s Bank of China) pegs the currency to the USD. The PBOC fixes a mid-point every day and the yuan is allowed to trade 1 percent above or below the mid-point. The sore point of governments in the US, eurozone and elsewhere is that an artificially held yuan helps Chinese exporters as it keeps the value of their goods sold in world markets down and makes it more competitive than countries where currencies are allowed to trade freely.

The fact that the PBOC is allowing the yuan to rise when it’s export-led economy is weakening is a surprise and one has to look for reasons such as the government wanting to make the economy less dependent on exports for letting the currency to rise. China’s gross exports stood at around 29 percent of GDP as of 2011 and is likely to have come off further in 2012 on weakening growth in its main export market of Europe. The euro area economy is expected to grow by only 1 percent in 2012 with many debt-ridden countries facing recession.

The rising yuan trend is not seen in other emerging market currencies. In the BRIC (Brazil, Russia, India and China) world, currencies of Brazil, India and Russian have depreciated against the USD over the last one year, with the Indian rupee touching record lows against the USD in 2012. Economic growth has deteriorated in Brazil, Russian and India with GDP growth forecast for 2012 at 1.5 percent, 3.5 percent and 5.5 percent respectively, down from 2.7 percent, 4.3 percent and 6.5 percent growth seen in 2011. The divergent trends in currency markets in the BRIC countries suggest that currency markets are treating each country on its merits and demerits rather than clubbing all currencies together.

USD has broadly appreciated against other majors

The USD has seen strength against other majors over the last one year. The most significant gain has been against the euro with the USD gaining 7.8 percent on the back of debt worries in the eurozone. The Korean won (KRW) has gained against the USD over the last one year despite the economy slowing down. The Korean economy grew at its slowest pace in three years in the September 2012 quarter at 1.6 percent GDP growth. The Japanese yen, which has gained over 40 percent against the USD and the euro over the last few years, saw some respite with the currency weakening over the last one year on slow export growth. In September 2012 exports fell 10 percent, the sharpest fall seen in recent times, indicating the weakness in the economy due to a strong yen and weakening economies of its main exports market of China and Europe.

Commodities are down, indicating global economic weakness

Commodity prices are reflecting a weak global economy with prices down on a year-on-year basis. The Reuters CRB commodity index that tracks a basket of 19 commodities is down close to 7 percent year-on-year while commodities from fuel to metals are also down. Outlook for commodity prices is not very positive given the weakness in global economies.

Where are financial markets headed?

The Chinese yuan is rallying, the US dollar is exhibiting broad strength against other majors and commodity prices are down. How do all these factors affect markets across equities and fixed income? Going from last to first, weak commodity markets are good for bringing down inflation expectations across the globe, but they are negative for commodity producers, including countries such as Brazil, Australia and Russia. Lower inflation expectations should keep down bond yields while weakening economic growth will make central banks across the globe ease monetary policy. Low interest rates will then feed into domestic consumption, helping economies come out of slumps. However this will take a while to materialise.

A strong USD reflects the relative strength of the US against other economies. There can be flow of capital into the US, leading to US equities and bonds gaining. Strong US financial markets help improve sentiments across the globe, leading to positive movement in global financial markets.

A rising yuan is broadly positive for emerging economies as it makes their exports more competitive against Chinese exports and also helps central banks loosen their hold on their currencies. Flows into emerging markets would improve as the yuan strengthens leading to positive movements in equity and bond markets in these countries.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com , a web site for investors.