Market Insider

How the Fed may be buying time for China

A sign displaying the Hong Kong dollar and Chinese yuan currency signs sits outside a currency exchange store in Hong Kong, China.
Xaume Olleros | Bloomberg | Getty Images

Global risk markets may have a reprieve from China-related shocks now that the Fed is clearly focusing on overseas headwinds.

Stocks tumbled in August and early January after sharply weakened its currency peg against the dollar, raising concerns it would further devalue the yuan and trigger a significant economic slowdown.

Now, some analysts say Federal Reserve Chair Janet Yellen's dovishness gives the world's second-largest economy breathing room to progress on its economic and currency policies — at least until the second half of the year, when another rate rise is possible.

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"Yellen has effectively explained the policy reaction function of the Fed. That now includes global market stability," said Athanasios Vamvakidis, head of G10 FX strategy in Europe at Bank of America Merrill Lynch. "What the Fed is doing is buying some time. Hopefully China will make the best of this time."

Analysts hope China can improve its communication methods and show it has a tough economic transition under control. That would help stocks, which were pummeled at the start of the year by recession fears.

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The global environment is "a legitimate concern to (Yellen). If it's a legitimate concern to her and it keeps her looser, I think we should stay bullish," said Ben Pace, chief investment officer at HPM Partners.

The Fed isn't alone in its concerns about the ripple effect from China. The International Monetary Fund said Monday that China-related shocks to global markets will only increase with the country's growing financial influence.

With the Fed's more-dovish-than-expected policy statement in March, the U.S. dollar index fell 3.6 percent for the month to bring first quarter losses to 4.1 percent, its worst quarter since 2010.

Unexpected strength in the yen and the euro, despite central bank easing, have also weakened the dollar index. That softness and China's efforts to play up the yuan's peg against a currency basket have helped stabilize the yuan, whose official midpoint fix against the greenback hit its strongest of the year so far on Friday.

The last leg of weakness in the dollar index also came after the late February G-20 meeting in Shanghai, stirring speculation of a "Shanghai Accord" in which global policymakers secretly agreed to halt the dollar's rise and prevent a negative spiral of weaker and weaker global currencies. The official commentary following the meeting maintained that no country would competitively devalue its currency.

Conspiracy theories aside, Yellen's specific mention of China and its currency in her latest speech suggests to some analysts that the Fed is focused on the dollar and the feedback of its actions on the global economy.

Jefferies' Chief Market Strategist David Zervos said in a note last Wednesday that Yellen took what he termed as the "CHEXIT trade" off the table in an effort to prevent financial market turmoil. "The reason I want to start calling it CHEXIT is the same reason we talk about GREXIT, BREXIT or FREXIT — it is the breakdown of union. In this case it is a currency union between the two largest economies in the world, China and the U.S.," he said.

"The big question in the months ahead centers on the European and Japanese responses to all this," he said.

In midday trade Tuesday, the yen traded around 110 yen against the dollar, its strongest since October 2014, while the euro was near $1.139 after recently topping $1.14 to its highest in nearly half a year.

With the Fed still on track to raise rates, HPM's Pace expects the U.S. dollar index to strengthen over the long term, while Vamvakidis projects the euro will reach parity with the dollar by the end of the year.

But as the second quarter kicks off, Vamvakidis expects muted currency moves in the near term.

As analysts say the Fed appears to be buying time for China to stem negative spillover, the country has shifted from making drastic currency moves to taking new efforts to promote capital market development. That includes implementing debt swap programs and, in a rare move, allowing state-owned steelmaker Dongbei Special Steel to default on a short-term note last week.

"It seems they want to focus for a while at least on potentially bad or potentially nonperforming debt and potentially come back to the currency later," said Paul Christopher, head global macro strategist at Wells Fargo Investment Institute.

In a nod toward the impact of the yuan, Yellen talked about China's shift away from a manufacturing economy and dedicated an entire paragraph of her prepared text last week to China.

"There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it," she said. "These uncertainties were heightened by market confusion earlier this year over China's exchange rate policy."

Yellen is scheduled to speak again on Thursday, along with former Fed chairs Ben Bernanke, Alan Greenspan and Paul Volcker.

Talk of global developments strays from the Fed's traditional dual mandate of keeping the domestic labor market healthy and inflation in check. But some embrace the attention on global markets.

It's a "welcome acknowledgement we don't live in a vacuum," said Scott Clemons, chief investment strategist at Brown Brothers Harriman.

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"It's not healthy to have China on the fringes pursuing their own policy system without regard to the global implications," he said.