An interesting correlation is developing between the Chinese yuan and the digital currency bitcoin. Amid tighter Chinese capital controls, bitcoin has become a popular vehicle by which households have moved money out of the country. Chinese individuals can buy bitcoin onshore, sell it offshore for a foreign currency and then move it back into a bank account - all quickly, anonymously and outside the control of a central authority. More than 90% of all regular global bitcoin activity comes from China, with that percentage rising to 98% over the past six months, according to bitcoinity.org. Bitcoin was 2016's best-performing asset, appreciating 125% as the yuan suffered its worst annual decline since 1994. The cryptocurrency remained on a tear during the holiday period, gaining 40% over the two weeks ending Wednesday, when it touched a new all-time high of $1,137. However, the yuan's bullish midweek reversal triggered a small crash in the value of bitcoin, which from Wednesday's high to Friday's low lost nearly 30% of its value. While a stronger yuan crimps motivation to shuttle money out of China, the biggest catalyst for bitcoin's steep losses was concern about potential new digital currency regulation. The People's Bank of China (PBoC) issued a cryptic statement warning bitcoin investors to be careful due to the currency's volatility. The central bank delivered a similar message warning financial institutions to steer clear of the digital currency in 2013, sparking a $300 slide in bitcoin's value. Officials from the PBoC's Shanghai branch also meet Friday with representatives of BTCC, a major Chinese bitcoin trading platform, prompting speculation about crackdowns. If capital outflows in China do not abate, it would be no surprise to see officials impose new rules, especially given bitcoin's potential role in money laundering schemes. While gold has slumped since 2011, bitcoin has taken its place as a hedge on uncertainty. In addition to developing an inverse relationship with the yuan, it often excels during periods of uncertainty: the Greek debt crisis, Brexit and India's war on cash being three recent examples. While bitcoin has largely been dismissed by mainstream investors, returns and volatility in recent years are forcing the financial establishment to take notice.

Dow 20,000 once again proved elusive this week, although the blue chip index on Friday set a new record high and came within 37 cents of the psychological milestone. Meanwhile, the 10-year U.S. treasury yield traded even further off post-election highs, down almost 30 basis points to 2.35%.



In the first week of 2017, the biggest story in financial markets remained China. Among risk factors with the potential to roil global markets this year, China sits at the top of the list.



Investors are closely monitoring the value of the Chinese yuan and pace of capital outflows for clues on economic stability in the world's most populous country. The communist government has been burning through foreign exchange reserves in support of the currency, with the trend continuing in December - albeit at a slower pace than expected. Reserves fell by $41 billion, to $3.01 trillion, in the final month of 2016. Analysts expected a drop of $51 billion after November's decline of $70 billion.



The slowdown in momentum could owe to tighter capital controls imposed by the Chinese government starting in November, including strict limits on large foreign business transactions. Fearing another wave of household outflows at the start of the year, the government this week imposed extra paperwork on citizens planning to use their annual $50,000 foreign exchange limit, including a pledge they will not use the currency to buy foreign property. It also imposed stricter punishments for violators, who will be denied currency quotas for three years and put under investigation for money laundering. While tighter regulation seems to have put a temporary band-aid on outflows, capital controls have the longer-term effect of eroding confidence.



The forex data came on the heels of two days of extreme volatility in the yuan caused by heavy-handed government intervention. On Wednesday and Thursday, the currency wrong-footed China bears with its largest-ever two-day gain. The offshore renminbi exchange rate jumped 2.6% against the dollar while the onshore rate climbed to its highest level in more than a month. The sharp move brought an abrupt end to the dollar's strong advance since the U.S. election.



The move was triggered by the People's Bank of China's (PBoC) decision to tighten interbank lending rates on the yuan. In response, the overnight deposit rate in Hong Kong quickly spiked to an all-time high of 80%, while the spread between offshore and onshore exchange rates widened to its biggest gap since 2010.



The Chinese government does not like people betting against the yuan. The currency slid 6% against the dollar in 2016 despite officials spending more than $1 trillion in forex reserves to support it, leading traders to bet on further depreciation. Without the tools to upend the renminbi's bearish fundamental outlook, the government decided instead to make shorting the yuan more expensive. To short the yuan, investors borrow currency in Hong Kong, swap it for dollars and then exchange it back into yuan in the future at a more favorable rate. Borrowing yuan comes at a cost, however, and if the Chinese government can make executing the trade expensive enough, it discourages short-selling and triggers price squeezes.



In addition to tightening inter-bank liquidity, the PBoC also set the yuan's official daily fix against the dollar at stronger-than-expected levels. The one-two punch forced banks in Hong Kong to tap the Hong Kong Monetary Authority to cover positions and meet trade obligations. Contributing further to the momentum was better-than-expected economic data as Chinese service sector activity rose to a 17-month high in December. However, in a sign of the artificial nature of the midweek move, offshore yuan pared gains against the dollar by 1.1% Friday, prompting many (including Goldman Sachs) to call the brief reversal a fresh opportunity to sell the Chinese currency.



It wasn't the first time Beijing has sought to squeeze traders out of short-yuan positions (and likely won't be the last). Early last year, a similar move in offshore yuan deposit rates engineered by the Chinese government triggered a protracted decline in the dollar. The greenback fell 6% on a trade-weighted basis between mid-January and early-May, only reversing its slide after the presidential election.



China is hoping to walk an impossible tightrope: gradually walk the yuan lower without triggering further capital flight. The task has been further complicated by an increasingly hawkish Fed and the appointment of several China critics to prominent economic posts with the incoming Trump administration. This week the President-elect named another China hawk, Robert Lighthizer, to head the U.S. Trade Representative office.



Although Chinese foreign exchange reserves fell at a slower pace in December, the pace at which they are declining remains unsustainable. At the same time, the government has been taking additional steps to cool credit expansion. New restrictions on property markets will soon weigh on mortgage issuance. Bond market volatility is causing companies to cancel new bond auctions. Banks are facing new limits on selling wealth-management products amid a crackdown on shadow banking exposure. As a result, speculation is again mounting that the Chinese government could be shaking yuan bears out of positions before conducting a larger one-time exchange rate adjustment putting the economy on a more realistic path.



The government is taking small steps toward reducing risk, but the question is whether they will tolerate the subsequent slowdown in growth. We've seen this movie before, with Chinese policy makers appearing to prioritize reform before getting cold feet at the first sign of economic turbulence. As Peter Lynch once said, the four most dangerous words in investing are "this time it's different." But during this episode, the Chinese government might not have a choice.