The coronavirus has rocked global financial markets this week although the effect has been limited in the G10 FX space compared to equity and commodity pricing.
The means of quantifying the impact the virus has on an industry level is arguably easier than assessing the true macroeconomic impact of the virus at this stage, which is why equity and commodity markets have been more sensitive to early estimates of the virus’ virulence.
For this reason most of the risk-off pricing has been siphoned through these markets as consumption, travel and industrial production faces demand and supply shocks, while bond markets have seemingly benefitted from haven flows.
FX markets on the other hand tend to be more sensitive to the macroeconomic implications and the external impacts it has on the global economy.
With the problems of estimating the macroeconomic impact at this early stage, FX markets have arguably been more robust to the pricing of the virus.
Although FX pricing has been less sensitive to the epidemiological metrics, it has been far from muted.
The impact from the event is undoubtedly linked to the impact it will have on China’s Q1 GDP data and its resulting impact on the global economy, while certain currencies feel the pinch from commodity markets too.
Early estimates suggest Q1 growth will fall by 0.6-1% QoQ, but these estimates are highly susceptible to revisions based on the incoming economic and epidemiological data.
Chart 1: Commodity linked currencies in the G10 space bear the brunt of the coronavirus outbreak while JPY and USD rally on haven flows (21/01 onwards)
Chart 2: Emerging markets also sit in the red with INR and TRY weathering the storm due to lower oil prices but commodity-linked and high beta currencies feel the force of a slowing China
Emerging markets have definitely felt the brunt of the coronavirus pricing due to the risk averse sentiment, reduced external demand from China for retail goods and services, and softer commodity prices.
The Chilean peso, for example, is the worst performing currency in both G10 and EM space as copper prices fell at an unprecedented rate while idiosyncratic risks persist in the form of rioting.
However, G10 FX markets haven’t necessarily found safety from the market’s wrath. Commodity linked currencies such as AUD and NOK standout as the worst performers since the outbreak hit the markets radar. On the other hand, the dollar has been one of the main beneficiaries of the coronavirus as flows flood into the safe haven that is the US treasury market.
US yields have fallen across the curve with the exception of short-dated T-notes. This move has sparked concern as the 3-month 10-year yield curve inverts again.
This was last seen during the peak of the US-China trade war, highlighting how extensive the flight to safety was.
Chart 3: US 3M-10Y spread inverts for the first time since peak US-China tensions while commodity prices tank
Recent headlines about the extended holidays in Shanghai and Guangdon suggest that panic hasn’t quite peaked, while official projections suggest the virus is set to peak mid-February.
The unpredictable nature of the virus has caused widespread disruption to China’s economy, disruption that may not be evident in next week’s data.
The timing of the PMI surveys, produced officially and by IHS Markit, looks as if it did not account for the initial impacts of the containment policy with responses expected in the second week of the month. Additionally, the January PMI data tends to be distorted by the lunar calendar.
These distortions are so significant that other data releases are normally put on hold for January.
The PMI data may not be the best measure for financial markets to begin gauging the macro effects of the virus for these reasons. However, the data is the best indicator of current activity until the end of February when further PMI releases are scheduled.
In the absence of timely economic data, and with onshore Chinese markets closed due to the extension to the lunar holiday, global market participants are trading blindly without either an economic or a sentiment gauge.
This may all change with onshore markets set to open again on February 3rd…
The PBOC are likely to set the fixing on Monday’s open lower to where offshore markets have been trading of late in order to not embolden currency speculation.
That being said, the last time USDCNY cracked the 7.00 level, due to the US labelling China a currency manipulator at a time of heightened trade tensions, the fixing was set at 6.9225.
We expect markets to re-open to a fixing lower than that too, potentially around 6.90, but notably this would still allow the breaching of the 7.00 level within the PBOC’s 2% tolerance threshold.
If this scenario were to play out, it would imply a moderate use of the countercyclical factor by Chinese authorities, but not the levels seen prior to CNY breaking 7.00 in September 2019.
On successive days, we expect the yuan to breach the 7.00 level as officials have shown an increased tolerance to a weaker yuan as part of their countercyclical programme.
While this may make purchasing agreements with the US more difficult to achieve in the short-run as it erodes purchasing power, a weakening of the yuan would provide a potential avenue of economic relief for an economy, which is likely to be substantially impacted by the initial containment measures and the proceeding loss of output.
Chart 4: USDCNY likely to break the 7.00 level but the fixing is unlikely to buffet market forces to the extent that it did in early September
Author: Simon Harvey, FX Market Analyst at Monex Europe.