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Yuan May Depreciate Further; Buy Cheap ETFs
Aspire | 13 October 2015
By: Lim Si Jie
Articles (169) Profile

Look out for China, not The Fed, for clues on your next investment, said David Woo, Bank of America’s Head of Global Rates and Currencies Research.

US Treasury Yield vs. S&P 500

Given the possibility of S&P 500 ending 2015 with a year on year decrease, and expectations of a Fed rate hike pushed until March 2016, ten-year U.S. Treasury yield should not still be above two percent. Yet, bond yields continue to stay above two thanks to U.S. Treasury bond sell-off from central banks around the world, especially the People’s Bank of China (PBOC).

China’s Influence on Markets

Central banks around the world are selling U.S. government bonds at the fastest pace on record, the most dramatic shift in the $12.8 trillion Treasury market since the financial crisis. In particular, the PBOC has also been selling U.S. debt in sizable amount, putting upward pressure on yields, in order to support its domestic currency.

This is an exemplary example of China’s ability to have outsized influence over both risk assets. As far as the broader market is concerned, China is still more important to Fed, according to David Woo.

Depreciation of Yuan Still China’s Game Plan

Woo believes that the most important development in 2015 has been the unprecedented rate of capital outflows from China, which is a result of the PBOC’s choice of currency policy: depreciating the Yuan.

The divergence in monetary policy between U.S. and China, the world’s two largest economies, has yet to be fully realized. Should The Fed raise interest rates, the PBOC will likely be forced to sell more U.S. Treasuries in order to maintain its dirty peg to the greenback. And according to David Woo, this would “compound the effect of a minor 25 basis point hike from the Fed” as PBOC’s sell off will put upward pressure on U.S. Treasury yields.

Overall, the end game plan for China is to let its currency depreciate as part of a package of monetary easing. David Woo’s instinctive forecast is that the yuan could be in for a drop of up to 10 percent.

Impacts of Depreciating Yuan

An eventual Chinese currency depreciation will play out in two phases:

First, the move would send a deflationary impulse around the world, inspiring competitive devaluations in select emerging markets and further weakness in commodity prices. The Fed would be unable to hike rates against this backdrop, and the yield on the US 10-year Treasury would slide. David Woo believes that US 10-year Treasury yield could slide to around 1.7 percent in this situation.

Secondly, the ensuing weakness might open the door for “Chinese-style QE,” which would send investors rushing into beaten-up emerging markets and basic commodities.

Investors Takeaway: Make Use Of Low Cost ETFs

If the first event plays out, and the world enters deflation, easy monetary policy will continue to keep US markets afloat. Investors might want to look at ETFs that are linked to the major US indices such as SPDR DJI AVERAGE, ISH CORE S&P 500 and LYX DJIA.

If the second event plays out, and “Chinese-style QE” takes place, investors can capture gains in the emerging markets through emerging markets ETFs like LYX MSCI EM MKT, DBX MSCI EM ASIA and DBX MSCI EM MKT.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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