FX: Should we Trade or Fade the Chinese Crash?

Daily FX Market Roundup 01.04.16

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management

The first trading day of 2016 gives investors a taste of the topsy-turvy moves they can expect in the financial markets this year. Between slower Chinese growth, underperformance in the Eurozone, uncertainty about how many times the Federal Reserve will raise interest rates and intensifying geopolitical risks, 2016 could be a year of great volatility for currencies, equities and commodities. The 7% decline in Chinese stocks overnight sent U.S. and European stocks down 2% or more. This led to a sea red for currencies with investors flocking into the safety of the U.S. dollar and Japanese Yen. The greenback traded higher against all the major currencies except for the Yen. Investors are nervous about China’s stock market crash because a deeper slowdown in China is one of the greatest risks for the global economy this year. While it is dangerous to read too much into one day’s move especially on a unique day like this when there are a lot of position adjustments, sell-offs in a nervous market can have greater continuation than rallies.

In the past 12 months there have been a number of instances where Chinese stocks experienced sharp one day declines (August, July and May) and only in August was there continuation but the move that month was brutal and one that affected markets around the world. It is too soon to tell whether today’s selloff will turn into a deeper correction because on one hand, part of the breakdown can be blamed on panic selling after circuit breakers kicked in and on the other China is experiencing a real slowdown. Aside from the weaker manufacturing PMI reports, this is the first year of China’s 5-year plan to focus on domestic consumption.

We believe the best way to trade today’s Chinese crash is to use limit orders. If the move is real, then tomorrow’s decline should be just as nasty and selling the lows in USD/JPY and AUD/USD could be smart trades. Alternatively, if you believe that the turmoil could lead to a less hawkish FOMC statement later this month or more trouble for Australia, you may want to consider limit orders to sell USD/JPY on the 120 handle or sell AUD/USD on the 72 handle. But it is important to remember that if Chinese stocks continue to fall, the Chinese government will not hesitate to step in to turn the tide around. There’s no question that the PBoC will increase stimulus this year especially given recent developments.

Interestingly enough, Fed officials remain optimistic despite the sell-off in China and weaker U.S. data. According to this morning’s ISM manufacturing and construction spending reports, the strong dollar continues to weigh on economic activity. However U.S. policymakers don’t seem worried. FOMC voter Mester said the U.S. expansion is on solid ground and she does not see China weakness as a significant forecast risk. Fed President Williams who is not a voting member this year agrees that the U.S. economy is in good shape and feels that the Chinese stock market doesn’t affect the U.S. directly. Fed Vice Chair Fischer was less optimistic on the outlook but his concerns center on the central bank’s ability to head off another financial crisis should it occur because of lack of coordination between inter-government agencies. With no major U.S. or Chinese economic reports scheduled for release over the next 24 hours, risk appetite will dictate forex flows.

The Australian and New Zealand dollars shed nearly 1.5 percent of their value against the U.S. dollar today. These 2 currencies were hit the hardest because of their reliance on China. It is no coincidence that Australian manufacturing activity slowed at the end of the year. New Zealand is also vulnerable but China’s demand for imported dairy and meat is less sensitive to the slowdown and could actually benefit from the government’s rotation towards a consumer driven economy. New Zealand’s first dairy auction will be held tomorrow and a rise in prices is critical for NZD/USD’s near term outlook. If dairy prices increase, NZD/USD will bounce towards 68 cents but if they fall, the 50-day SMA at 0.6670 could be tested.

USD/CAD rose within 15 pips of 1.40. Crude prices were little changed but had turned negative after trading sharply higher intraday. A significant amount of Canadian data is scheduled for release this week and we are looking for the reports to show ongoing weakness in Canada’s economy. USD/CAD may pull back but another move above 1.40 should happen this week.

An upward revision to Eurozone PMIs helped euro stave off deeper losses. EUR/USD traded as low as 1.0781 but bounced back above 1.08, an important support level as the selling eased. Tomorrow’s labor market report from Germany should also help the currency because according to the PMIs there was strong job growth in the manufacturing and service sectors. Inflation on the other hand remains low with consumer prices turning lower in the month of December because of falling oil prices. The move in prices show exactly how sensitive CPI is to the currency as the decline was driven largely by the rebound in the euro last month.

The British pound also ended the day unchanged despite weaker data. Manufacturing activity in the month of December expanded at its slowest pace in 3 months. Considering the importance of the PMI report, we are surprised that the losses in GBP/USD were so limited. Regardless now that the currency pair is trading below 1.48, there’s no major support until last year’s low of 1.4566. In order for the 180-pip move to occur, we need either continued risk aversion or a soft UK PMI services report.

Leave a Comment

Hide me
Receive Thought Provoking Forex Commentary Directly to Your Inbox
Show me