China's currency devaluation ripped global risk markets, but the real fear is that what's behind the move could be a bigger problem for the world economy.
Global stock markets fell and commodities were crushed. Emerging market equities were casualties, and currencies from the Mexican peso to the Australian dollar were smacked. The U.S. dollar was higher against a basket of currencies, and buyers moved into the safety of bunds and Treasurys, driving yields sharply lower. The U.S. 10-year was yielding 2.13 percent.
"It's a little bit of damage to the global growth psychology. If the country that's been growing the fastest and been one of the mainstays of global growth momentum ... is allowing their currency to sink a little bit, if they're resorting to that, how bad are things around the world?" said Robert Sinche, chief global strategist at Amherst Pierpont Securities.
China on Tuesday surprised the world with the largest devaluation of the yuan in its history. The People's Bank of China sets a daily fixing value for the yuan at a midpoint against the U.S. dollar. In daily trading, the Chinese currency is allowed to move 2 percent above or below that midpoint. The yuan's fixing was weakened by 1.9 percent Tuesday. China said the midpoint diverged from the market rate for a long time and that it was making it more market-based.
"I think it creates uncertainty about where things go," said Sinche, adding he expects another move by China, totaling about 5 percent.
"If it's a meaningful move, then those that are competitors of China will suffer. At 5 percent, I'm kind of at the high end of what people think they would do. Five percent is barely noticeable. It's more noise than substance. ... Part of this is to placate domestic producers. They're trying not to do the big fiscal stimulus thing so they're trying to pull a lot of little levers."
But the move, nonetheless, spooked world markets. U.S. stocks were slammed along with emerging markets. The Dow was off 1.2 percent to 17,402, and the S&P 500 was down nearly a percent at 2,084. Developed markets were hit as traders worried that China's economy would slow enough to impact sales of everything from cement to automobiles. The German DAX was down 2.7 percent.
"The key is if we knew this was going to be the end of it—the 2 percent devaluation—I think the markets would bounce back," said Marc Chandler, head of currency strategy at Brown Brothers Harriman. "The problem is people don't think this will be the end of it."
The move triggered immediate speculation that the Fed would hold off on raising interest rates in September, as many expect. But Michael Feroli, chief U.S. economist at JPMorgan, said it's unlikely the move will stop the Fed, as it will be seen as a "minor headwind to growth."
"Even if one incorporates the knock-on to other EM Asian currencies, which are another 14.5 percent of the dollar index, the immediate growth (and inflation) impacts aren't large," he wrote in a note.
China's exports for July fell 8.3 percent, news that initially triggered a risk rally Monday on the hopes of fresh Chinese fiscal stimulus.
Sinche said the rising dollar, moving on better U.S. data and expectations of a Fed rate hike, hurt currencies in the emerging world, like the Mexican peso. That made the currencies of export countries more competitive than China's yuan, so for him, it was no surprise the PBOC moved in response. The Mexican peso was near an all-time low against the dollar and lost another 1 percent Tuesday.
South Korea's won lost nearly 2 percent Tuesday to a three-year low against the dollar.
The PBOC move also sparked a selloff in commodities as traders feared China's economy is slowing more than expected, and demand for raw materials will be even weaker. Oil ended the day more than 4 percent lower. West Texas Intermediate crude futures fell 4.2 percent to $43.08 per barrel.
"Overall, I think this devaluation by the Chinese suggests maybe the slowdown in economic growth is greater than people anticipate, and that's where fear on the demand side is coming from and driving us lower," said Gene McGillian, analyst with Tradition Energy.
The move lower in commodities also weighed on the currencies of commodities exporting countries, like Australia, New Zealand, Canada and Brazil. The Australian dollar was about 1.7 percent lower against the greenback.
"I think that broadly speaking for Asian currencies, there is a fear this is going to trigger a currency war," said Chandler, adding he does not expect that to be the case.
"Broadly speaking, up until now, people have largely thought of it being a commodity supply issue but China has told us it's demand side. The whole process is bad for China, bad for those currencies that are related to commodities."