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Shanghai composite plummets as data shows patched recovery

After a 24% rally in their stock market from the start of July, the Shanghai Composite index saw a sharp reversal down 17% as data shows a patched recovery in China.

Bloomberg reporting industrial output was lower by 1.3% while retail sales plummeted 11.4%, showing strong weakness in the consumer, which use to be the backbone of many economies. Michelle Lam, China economist at Societe General SA in Hong Kong, stated that the recovery was "driven by credit stimulus as evident in the strong infrastructure and property investment, while the recovery in sales in retail sales and private investment has continued to lag."

It is interesting to note that the strong infrastructure and property investment gains are on the back of the PBOC's wary of cutting rates earlier in the year when the Coronavirus hits. In favour of a more direct approach, China issued bonds, facilitated direct lending and lowered the reserve ratio required for banks to provide liquidity into the money markets. These measures injected more than 1.7 Trillion Yuan ($220 Billion) of liquidity into the money markets. This is a stark contrast to how 38 other central banks around the world tackled the Coronavirus early this year by slashing interest rates. Michelle continues, stating that "Policymakers will probably save bullets and hold back broad-back easing and find the current growth trajectory acceptable." This sentiment is backed by Ma Jun, a PBOC adviser, stating that "the PBOC doesn't use all its bullets at once. China has plenty of room in monetary policy."

China has been giving investors something to cling on to

The recent bull run has given many Chinese retail traders great euphoria. Bloomberg documented Min Hang, who opened her trading account, stating that "There is no way I can lose" and that "[she] feels invincible." The rally added $1 Trillion of value in the span of 8 days, topping China's equity market valuation to 10 trillion – the top of the bubble in 2015. However, being known as the world's manufacturer, China continues upward hinges on the global economy to recover. Ding Shuang, chief economist for China and North Asia at Standard Chartered, stated that Coronavirus around the world continues to affect businesses around the world, which "may weaken demand for China's goods and services and is the main risk facing China's economy."

This highlights a significant problem with Globalization: Dependency with all the other markets. Amid a trade war between China and the United States, Globalization faces an imminent threat akin to mutually assured destruction. With both countries' interests in the forefront of their foreign policy, they are blinded to the fact that in this day in age their rely on each other more than they give each other credit for.

Are you riding China's bull market?

Will Hong Kong abandon the peg against the USD?

Will Hong Kong abandon the peg against the USD? The financial hub of Asia, which connects the East to the West has been in the middle of pissing contest between the United States and China, not to mention their domestic struggle between them and China. If protests for autonomy in Hong Kong continue, and President Trump implements drastic foreign policy measures against Hong Kong, extreme capital outflows may ensue, forcing the Hong Kong Monetary Authority to abandon its peg on the U.S. dollar.

Could Donald Trump’s election woes force the Peg to break?

As the November Election edges nearer, President Donald Trump risks losing the presidency due to his mismanagement of the Coronavirus. David Rocke describes his reopening the American Economy as “gambling for resurrection.” A branch of game theory, which essentially states everything that the President is doing with regards to the Coronavirus is perfectly rational. He has two choices: He does nothing drastic, the death increase, therefore basically ensuring his loss in the election. Or he reopens the economy, maybe squashes the curve, and promotes that it was a success, giving him a higher chance of winning the election. If that doesn’t work, well, he was going to lose the election anyway. As the Jobless claims reached 41 Million yesterday, President Trump is losing the grip on the election. Desperation may be a giant risk for Hong Kong's peg.

However, there is one thing the President has full control over – foreign policy. With a China conference set tomorrow, there a high possibility given his election chances that he implements drastic sanctions against Hong Kong to please his supporters. This is alongside Secretary Pompeo announcing that “It could no longer verify Hong Kong’s autonomy from China,” which gave it special trade exceptions with the U.S. This may put upwards pressure against the Hong Kong Dollar, which is pegged against the USD as the financial instability from the sanctions may cause extreme capital outflows. However, this alone may not cause a capital outflow, nor may the capital outflow force the peg to break. Hong Kong may impose restrictions on capital outflows for the time being.

History of the Hong Kong / U.S. Dollar Peg

As the financial hub connecting the West to the East, Hong Kong teased investors with its free-flowing capital policies, with a promise of financial stability and consistency. In 1983, the currency was pegged to the USD. This was due tp Concerns regarding the future of Hong Kong after 1997, when the handover of control from the British to China was set to take place. The rate at which the Hong Kong dollar was pegged to the U.S. Dollar has changed over time, however, for the past 37 years, it has remained pegged to the U.S. currency. For the past 12 years since the Great recession, Hong Kong has flourished being the brokers between the East and the West. The pegged currency gave the country stability when it came to trade and investors.

However, history shows that pegged currencies are disastrous in extreme conditions.

This was the case in the Thai Bhat in 1997 and the Argentinian Peso in 2000. In the case of the Thai Bhat, Thailand was experiencing high levels of growth from 1992 onwards as banks loosened restrictions, causing a lending boom and inflated real estate prices. However, from 1995 onward, growth slowed, with investors increasingly worrying about the returns on their investments. This caused a massive capital outflow out of Thailand, devaluing the Thai Bhat. The government tried to prop up the currency by using its allocated $38B USD foreign reserves. However, in half a year from the start of 1997, their foreign reserves dropped 93% to $2.65B before they stopped the regime.

Thailand's Foreign Exchange Reserves from 1995-1999

The Thai Bhat subsequently depreciated against the USD, from 25 to 52 Thai Bhat per $1 USD, effectively abandoning the peg between the Bhat and the USD.

Exchange rate of the Thai Bhat against the USD

Similarly, the Argentinian Peso shared the same fate

Argentina’s government was citing the control of inflation as the reason for the currency peg. However, a multitude of socioeconomic factors such as an increase in income inequality and external shocks driving interest rates higher would see Argentina’s growing economy stall. With the Peso pegged to the USD 1:1, there was pressure for Argentina to keep the peg as most of its debt was denominated in U.S. dollars. However, restrictions on withdraws of 1000 Pesos/USD dollars pushed the sitting President, and the Minister of Economy resigned. The new finance minister imposed a new exchange rate of 1.4 to 1 U.S. dollar, however, what sealed the abandoning of the peg was when “pesification” of all the accounts in Argentina – which changed every single dollar that was in USD to Peso. This saw an increase in demand for the U.S. dollar – increasing the exchange rate from 1.4 pesos to 1 USD to around 4 Peso to 1 USD. Currently, 1 U.S. Dollar sits at 68 Argentinian Pesos. – Further reading, “Convertibility Law”

Exchange rate of the USD against the Argentinian Peso

What is the Catalyst for Hong Kong?

It will require a multitude of events to occur at the same time. The Hong Kong protests, for the most part, have been mainly domestic, with geopolitical parties watching from the sidelines. However, with China putting its foot down and enforcing national security law, the eyes of democracy have caught attention. President Trump stated that “we are not happy with China” with Larry Kudlow stating that China has made a “huge mistake” in passing the national security regarding Hong Kong. Carrie Lam, the Chief Executive of Hong Kong, assures Hong Kong citizens that the law will not undermine the freedom Hong Kong citizens face. However, she is on the side for the law passing, stating that “regrettably, the current legal system and enforcement mechanism for Hong Kong to safeguard national security [this is regarding the protests] are inadequate or even ‘defenseless.’ Despite returning to the Motherland for 23 years, Hong Kong has yet to enact laws to curb acts and activities that seriously undermine national security.”

Currently, Hong Kong’s Monetary Authority (HKMA) foreign reserve sits at around $441B U.S. dollar with Hong Kong using the Fed’s repo facility to its full advantage. The HKMA has the goal of pegging the currency between 7.75 – 7.85 HKD for 1 USD, and currently sits around the strong end of the band at 7.752 as the HKMA bolsters the strength of the HKD during the Coronavirus. This may be in anticipation of a devaluing in the currency because of the Coronavirus and domestic tensions.

Tensions are slowly picking up, putting pressure on the peg.

With the election on the horizon for Trump alongside China taking a strict stance against Hong Kong, fireworks may ensure as both sides battle it out. With Hong Kong directly in the firing line, all eyes are on what President Donald Trump imposes on Hong Kong tomorrow. The HKMA has enough foreign reserves to continue to prop up the HKD, given current circumstances. But the uncertainty with Hong Kong has finally started to settle in – not a feeling you want when your country was built on ensuring certainty and consistency within the Financial Markets. There is a chance that capital in Hong Kong talks themselves into pulling their money out of Hong Kong. If that occurs, the peg on the Hong Kong Dollar may serve the same fate as Thailand in 1997.

Risk on prevails pushing stocks higher

It is a firing start to the trading week as significant indices are in the green as risk on prevails. The SP500 reached a gain of 3%, breaching that psychological 3,000 mark. Although bears took some control near the end of the trading day, the sentiment was overall bullish.

I feel as though we have seen this repeatedly for the past 2 weeks. Restrictions on lock down are loosening, major central banks are providing unprecedented amounts of liquidity, and the backbone of the US economy, the consumer, is shopping again. However, recent economic data is disastrous; central bankers' words don't match the markets, and tensions between geopolitical parties have only gotten worse. Why has the market been so detached from real life recently?

SP500 popping off at the start of the US trading week for the past two weeks

Risk on in a low yield environment, killing institutional investors

With interest rates all around the world nearing 0%, institutional investors are grasping onto any positive yields in the market. It could also be due to an influx of all around the world retail investors "buying the dip". Another reason could be traders moving big lots taking advantage of the risk-on / risk-off dynamic. Whatever the case, it is evident that this risk on/risk on dynamic will continue to prevail in the markets if there is no vaccine.

However, there are some real markers of the economy recovering

The AUD/USD pair typically associated with risk on has been rallying in the past couple of weeks. With manufacturing across the world slowly starting up again, signs of economic activity have been showing. With summer arriving in a couple of days in the United States, a pick-up in oil demand is predicted to occur as Americans scratch the urge to take a holiday in a period where air travel still leaves a distaste in many peoples' mouths.

Tensions are rising in this risk on rally

It would be reasonable to think that in times like these, where a virus had ravaged the world out of nowhere, there would be unity and cooperation between all geopolitical powers. However, it seems like China has setting many bridges on fire lately. China against the United States, Hong Kong Taiwan, Australia – is not the sign of unity. However, it is not just China throwing hands. United States cutting ties and funding with the WHO is another example of how politics gambles with regular people's lives.

As China and Hong Kong protests start up again, concerns over the future of Hong Kong become real. 3 days ago, China's parliament said that it would impose a new national security law, with Hong Kong Citizens fear that this may be the last straw before the freedom that they have had enjoyed under colonial the United Kingdom's colonial rule. A Hong Kong expert at the Shanghai Institutes for international studies, Zhang Jian, told the Financial times that the national security law "Will reignite the protests but that's not a reason to give up [with regards to Xi's power move into Hong Kong] ".

We have yet to see an ounce of certainty in the past two weeks. Traders should be cautious and keep an eye out on any news that may fundamentally affect their trading strategy.

Andre Almeida has brilliant analysis technical on USD/CAD. You can watch it here.