In our last paper we outlined our bias for the USD to face headwinds in Q1, and our experience of price so far this year provides little reason to change this view. The Dollar Index (DXY) continues to retreat from multiyear highs as we approach a potentially turbulent quarter in the new year and the Fed plans to hit 3% interest rates by late 2019.
There are two drivers of instability in the first quarter (Q1) of 2017: the political landscape surrounding Washington, Beijing and Brexit is complex, and so is likely to result in complex price action; and, the Dollar rally seen in Q4 2016 will not be sustained, leaving it vulnerable to a correction or wide swings along the way (even if it does break to a new high).
As the Trump administration takes office, they appear determined to continue labelling China as a currency manipulator.
From a technical standpoint this is impossible: China only meets one of the three criteria to be labelled this way. These include: trade surplus with US above $20bn: ($325bn as of 2015); current account deficit above 3% of GDP: (Currently 2.7%); and, repeated depreciation of a currency.
It is possible Trump may seek to change these criteria to force this truth, which will have a negative impact on the People’s Bank of China (PBoC)’s efforts to slow the pace of the Yuan’s depreciation.
In the face of US threats of import tariffs, strong rhetoric on the disputed South China Sea, and Trump’s apparent disregard for the one China policy, it calls into question whether the PBoC’s intervention on the 4th of January (that resulted in USDCNH falling around 1.3% on two consecutive occasions) was politically timed for Trump’s arrival.
Trump has made comments referring to the “high US Dollar”, which could weigh further on the Greenback if this rhetoric continues. Trump’s cabinet pick for Secretary of Treasury, Steven Mnuchin, sees the higher dollar as a net positive to attract investment over the longer-term, but any divisions among Cabinet members and the President on such matters are likely to result in confusion for investors and subsequent price behaviour.
USDCNH has been a good barometer of USD sentiment
In recent months, we have used UDCNH as a sentiment gauge for Dollar strength. Throughout much of its advance, pundits, analysts and traders were sceptical the rally would last as, at any moment, the PBoC could intervene to send it lower. And while the PBoC has intervened along the way, the bullish trend between March-Dec 2016 has orderly.
Each time we see USDCNH move notably higher without PBoC washing the Yuan bears out of positions, it has proved an excellent barometer for broad USD strength and global sentiment. However, the reverse is also true.
When the PBoC has intervened to ward off speculation, global markets also jolt and in the past it has at times taken weeks and even months for markets to fully regain confidence. This is what the new year has brought, and we expect it could take several weeks for markets to regain confidence in a sustainable move in either direction. In our view, the political landscape only makes this scenario all the more likely.
We can identify three peaks since 2015 that coincide with interventions from the PBoC: 1) 12th August 2015, 2) 7th January 2016, and 3) 3rd January 2017. These three peaks have each produced different price behaviour that bear consideration with regards to the USD.
The peaks of 2015 and 2016 were both followed by corrections to initial moves. The trajectory of their declines were similar—orderly if a little inconsistent—and both arrived after a surge higher in the cross to denote sudden weakness for Yuan.
The most recent peak earlier this month however presents a different picture. The final bullish move preceding this peak’s depreciation was less impressive than seen in peaks before, but the initial decline was far more abrupt. This suggests the possibility of further downside as prices try to stabilise.
USDCNH currently remains above the bullish trendline from the August 2015 low and above a cluster of support around 6.76. This is an important area to monitor because any break beneath it, or bullish continuation above it, is likely to result in broader US Dollar weakness.
For a clear move in either direction the picture must become clearer between Washington and Beijing, which we feel as unlikely at this point.