Dollar Consolidates as Market Shrugs Off China Downgrade

china economy

  • The main development today was Moody’s decision to cut China’s credit rating to A1 from Aa3 
  • The Bank of Canada will leave rates on hold; FOMC minutes are unlikely to be very revealing  
  • The CBO scoring of the health care reform bill that passed the House of Representative is important 
  • Bank of Thailand kept rates steady at 1.5%, as expected; Duterte declares martial law on Mindanao island 
  • South Africa April CPI rose 5.3% y/y vs. 5.6% expected; Mexico mid-May CPI is expected to rise 6.10% y/y 

The dollar is mixed against the majors. Kiwi and Stockie are outperforming, while the Swiss franc and Nokkie are underperforming. EM currencies are mixed. ZAR and TRY are outperforming, while KRW and PHP are underperforming. MSCI Asia Pacific was flat, with the Nikkei rising 0.7%. MSCI EM is down 0.1%, with Chinese markets flat. Euro Stoxx 600 is up 0.2% near midday, while S&P futures are pointing to a higher open. The 10-year US yield is flat at 2.28%. Commodity prices are mostly higher, with oil up 0.2%, copper down 0.3%, and gold up 0.1%.

After staging a modest recovery in North America yesterday afternoon, the greenback is consolidating in narrow ranges. Momentum traders, who appeared to dominate activity recently, paused. To be sure, the greenback’s upticks have been modest, and little technical damage has been inflicted on the major foreign currencies.

The main development today was Moody’s decision to cut China’s credit rating to A1 from Aa3. It cited the risk of a material rise in economy-wide debt levels as the economy slows. The outlook was shifted to stable from negative. It is Moody’s first downgrade of China since 1989. Our own sovereign ratings model has China’s implied rating at A+/A1/A+. We have been warning of downgrade risks from S&P (AA-) and Moody’s, but Fitch’s A+ appears to be on target.

The impact was marginal. In part, this is due to the exaggeration of the internationalization of China. Specifically, China’s external debt is low at around 12% of GDP. The PBOC estimates that foreign investors owned about CNY830 bln (~$121 bln) of mainland bonds at the end of March, compared with CNY853 bln at the end of 2016. That is equivalent to about 1.5% of the CNY63.7 trillion outstanding.

Chinese shares initially weakened but recovered and closed fractionally higher. The price of industrial metals fell, but it is difficult to say the downgrade was the spur. Iron ore fell 4%, for example, after falling 3% yesterday. Nickel fell 1.7%, while copper slipped 1%. Among the currencies, the Australian dollar and the Malaysian ringgit seemed to be the most sensitive, but both recovered fully.

There are three events in North America that are noteworthy. These are the Bank of Canada meeting, the Congressional Budget Office scoring the health care reform that already passed the House of Representatives, and the FOMC minutes.

The Bank of Canada will leave rates on hold. The economy has generally evolved as it has expected. However, there is little reason to abandon its cautious posture. The risks from trade are significant. NAFTA negotiations begin in a few months. Although the White House has balked at the border adjustment tax, the vacuous nature of the Administration’s budget gives breathing space to the ongoing efforts in Congress to keep it alive. The Canadian economy has accelerated faster than the US, but the output gap is only slowly closing, and a rate hike seems unlikely over the next few quarters, at least.

The Canadian dollar staged a key reversal on May 5, after the US dollar almost reached CAD1.38. Since then, the US dollar has fallen about 2.5% against the Canadian dollar to hit almost CAD1.3455 yesterday. The speculative market is leaning the other way, as non-commercial accounts have a record gross short CAD position in the futures market as of a week ago. With US dollar resistance seen around CAD1.3550, there is potential toward CAD1.3440, which corresponds to a 61.8% retracement of the greenback’s rally that began in mid-April.

The CBO scoring of the health care reform bill that passed the House of Representative is important. It is the official arbiter of such issues. If the deficit is not reduced by two billion dollars over the next decade, it is possible that the bill is modified again and a new vote is needed. This is problematic because the bill passed narrowly (217-213) before and it was a delicate and fragile balance. A new provision that had been added allows states to waive some regulations that could lead to more people becoming eligible for tax credits, which has deficit implications. Recall that the savings from health care were going to be used to fund tax reform.

Although many will look at the FOMC minutes, it is difficult to imagine the minutes will be much more revealing that the meeting itself, which was as much of a non-event as an FOMC meeting can be. The FOMC statement looked through the recent softness of the US economy and said nothing to dissuade ideas that the Fed is poised to hike rates in June. Given that the minutes pick up sentiment from non-voters as much as voters, the risk seems asymmetrical for more hawkish rather than dovish minutes. It still seems early to expect many revelations about the balance sheet strategy.

Note that tomorrow New Zealand’s milk coop will set initial prices for the new fiscal year, and separately the government may announce that the economy’s performance is generating greater revenue. It is likely to announce modest tax cuts ahead of the September election. This may allow the New Zealand dollar to extend its recovery. It had fallen to a one-year low on May 11 near $0.6820. It pushed above $0.7000 yesterday. Offers were seen in front of $0.7050, but near-term potential extends toward $0.7100.

The euro is trading with a slight downside bias. A break of $1.1150-$1.1160 could squeeze more momentum players and spur losses toward the $1.1080-$1.1100. Option expiries today include $1.1140-$1.1150 (~1.5 bln euros). The dollar is in narrow ranges against the yen (~JPY111.75-JPY112.05). There is a large (~$2.55 bln) JPY112.0 strike that expires today. The intraday technicals warn that it will likely be a fight there today. Sterling is wrestling with the New Zealand dollar for the top position today, but it has so far been unable to resurface above $1.30. Although the low in sterling is debatable, 38.2% retracement of the sell-off since last year’s referendum (according to Bloomberg) is found near $1.3055. Thus far this has capped the resurgent pound.

Philippine President Duterte declared martial law on Mindanao island due to renewed clashes between government troops and militants linked to ISIS. This is the first imposition of martial law in the Muslim region in the south since 2009. It will be in place for 60 days. Defense Secretary Lorenzana said martial law would likely include the setting up of checkpoints, curfews, and suspension of any writ of habeas corpus.

Bank of Thailand kept rates steady at 1.5%, as expected. The decision was unanimous. The BOT noted that policy should stay accommodative. CPI inflation eased to 0.4% y/y in April, further below the 1-4% target range. This will allow the BOT to stay on hold for now.

South Africa April CPI rose 5.3% y/y vs. 5.6% expected and 6.1% in March. This is the lowest rate since December 2015 and back within the 3-6% target range. The SARB meets Thursday and is expected to keep rates steady at 7.0%. After its last meeting March 30, the bank signaled that the tightening cycle was over. Indeed, one MPC member voted for a 25 bp cut then. While we think it’s too early to consider a rate cut now, the SARB statement should tilt a little more dovish to set the table for a cut in H2.

Mexico mid-May CPI is expected to rise 6.10% y/y vs. 5.62% in mid-April. If so, this would be the highest inflation rate since 2009 and certainly supports Banxico’s decision last week to hike rates 25 bp. Another hike in June is possible if the Fed hikes on June 14. Mexico then reports April trade and Q1 current account data Thursday.