What happens if the renminbi devalues?



Part of the answer depends on how the price action develops. A chaotic, gap-like move of more than a couple of percent with a continued slide in the wake of the initial move would prove the most disruptive and would up-end risk appetite the world over, kicking weak asset markets when they are already down in what could be a worse version of the August 2015 renminbi devaluation announcement and the ensuing deflationary fears that washed over global markets – especially emerging markets – until early 2016 when the Fed raised the red flag on the USD strength and China stepped into staunch the CNY weakness. The idea is that a weak CNY is deflationary and turns the inflation risk narrative on its head. Global commodity prices would be hit hard as would risky asset prices in general.



What would do well? The general rule in events is that only the most liquid instruments do well – so the US dollar and US Treasuries would likely spike. The weakest currencies in this scenario would likely be the most China-linked exporters like Singapore (SGD), South Korea (KRW), Thailand (THB), Indonesia (IDR), Malaysia (MYR), etc. and even AUD and NZD. But in general, any smaller currency would likely perform poorly. Elsewhere, it is uncertainty whether the JPY would outperform even the USD – positioning would suggest that the JPY could be an even bigger mover than the USD to the upside as Japanese savings sloshing around the world look to deleverage and as the market is still rather short of JPY.



A less severe move in the CNY to the downside could still see a lower volatility version of the above.



Beware of the volatility acceleration



Just overnight we got a sense of how sensitive other markets are to a CNY move. The USDCNY rate was allowed to drift to new highs for the cycle and for the last decade, but still less than 0.18% above the previous day’s highs. This was enough to push AUDUSD almost a full percent lower to new lows for the cycle after the pair had traded in a narrow range in previous days.



This small example would likely be multiplied many times over on a real move in the CNY exchange rate of a mere full percentage point lower or more as the market won’t have a feel immediately for how the exchange rate might be allowed to go. The rising volatility in all asset classes triggers the classic deleveraging that sees correlations across markets rapidly heading to one, aggravating the search for safe havens.



Right now as of this writing, markets are trying to find a bit of comfort as the USDCNY rate drifts back below 6.94 after touching that ten-year high at 6.9682 overnight, but if the Chinese authorities want to send a stronger message that they don’t want to allow a CNY float to unfold, they will need to take the level much much lower (CNY stronger) – back to perhaps below 6.80 or lower. Stay tuned and understand that this exchange rate and China’s management of it over the next days will determine everything.