Thursday's Open: A Pause Or Short-Covering Rally?

 | Jan 21, 2016 06:07AM ET

The turnaround mid-session in the S&P 500 overnight seems to have coincided with some stabilisation in markets globally. Asian markets tentatively pushed into positive territory today, but it is hard to escape the feeling that this is just pause on the way down. The Shanghai Composite opened down, but after a few hours of trade had joined other markets in the green (red for them). Although late in the session sentiment did seem to be cooling as the Nikkei 225 briefly dipped into negative territory and the yen began to push back toward the 116 handle.

  • The temporary bounce in sentiment we are seeing globally has taken the pressure off a lot of asset classes. No more so than the Hong Kong dollar, which was straining at its upper bounds around 7.83, but has returned to trade back around 7.81. Unfortunately, this bout of selling in equities is unlikely to have ended today nor has the depreciation pressure on the CNY, which has been spilling over into HKD speculation.
  • Weak data and also the seasonal requirements ahead of the Chinese New Year holiday, which begins on 8 February, have prompted the largest injection of liquidity through open market operations by the PBOC in three years. This resulted in a net injection of CNY 315 billion this week, but, coupled with the PBOC’s other lending tools, roughly CNY 1 trillion was added this week.
  • Unfortunately, the feedback loop we are seeing in China of capital outflows -> declines in FX reserves -> tightening of the monetary system -> growing deflationary pressures -> easing of monetary conditions -> CNY depreciation -> more capital outflows is unlikely to end anytime soon. Given such a scenario, one can see why a one-off 10-15% devaluation of the CNY could be compelling. Certainly, the quelling of short-selling speculation in the offshore CNY has removed some short term pressure, but further depreciation of the CNY is inevitable. Particularly, when one looks at the amount of FX Reserves that are being lost. An IMF research paper in 2014 looking at FX reserve adequacy, used the ratio of FX reserves to M2 money supply and concluded that “the upper end of a prudent range for reserve holdings is typically set at 20 percent”. As one can see, China crossed this level of “prudence” in 2014 and its ratio now sits at 15.2%.