Goldman Unveils The FX Doom Loop:

Turns "Outright Negative" On Yuan Due To "Weak Link"

by Tyler Durden - 10:17PM

 

When we first presented the so-called "Nightmarish Merry Go Round", dubbed so by Bank of America because of the reflexive, recursive bond - and trap - that has formed between the Fed and markets...

... in which neither can break free from the other, and yet each is more dependent on the other than ever, we said that instead of looking at the relationship as one between the Fed and the market, one can further simplify the relationship as one between the USD, a proxy for Fed tightening or easing intentions, and the Chinese Yuan, a proxy for the Chinese economy, capital outflows and general volatility.

Today, Goldman has released a note which lays out precisely this relationship in what it calls the "RMB-FOMC Monetary Policy Loop", but before we introduce yet another firm's realization of just how circular the relationship between central banks and markets has become, here is Goldman's abrupt reversal on what it think will happen to the Yuan in the near-future, because as Goldman's Robin Brooks - who has been relentless bullish on the USD - now says that "we shift to an outright negative view on the RMB, in line with this week's Asia Views and our bearish RMB forecast."

The reason for Goldman's sudden bearishness is "because there is a weak link in China’s management of its currency."

This is how it explains the link:

"To be sure, the government has clearly communicated a shift in focus to a trade-weighted currency basket, de-emphasizing the signal that the bilateral exchange rate versus the Dollar carries. But domestically, the only signal that matters is $/CNY, so that higher fixings could easily re-ignite capital flight, as households and firms anticipate a faster pace of depreciation."

 One need look no further than the recent spike in bitcoin driven by Chinese buying to see this in action, as the local have been scared out of their wits by relentless PBOC intervention in the FX market. Gpldman goes on:

Even though global markets have so far taken weaker fixings in their stride, one regularity over the past year has been that the SPX has fallen sharply within a week or two of $/CNY fixing meaningfully higher, as focus on capital outflows and RMB depreciation has built.  

 

 

We believe that the risk of a repeat is rising, which in turn could have knock-on effects for the pace of Fed tightening and Dollar strength ahead. We call this the “RMB-FOMC Monetary Policy Loop,” where the importance of the bilateral $/CNY rate domestically may slow the pace of Fed monetary policy normalization, which our US team has also highlighted."

The implication: sliding CNY means risk off:

[T]he shift to a trade-weighted exchange rate has a weak link, which is that the main signal for households and businesses within China remains the bilateral exchange rate versus the Dollar. As the $/CNY fix has moved higher again over the past month (Exhibit 1), the risk is that this re-ignites capital flight in the same manner it did in August (during the mini-devaluation) and around the turn of the year. This is because capital outflows are heavily expectation-based, such that weaker fixings inevitably fan anxiety that a bigger devaluation is in train. In short, while the shift to a trade-weighted regime certainly makes sense, China is saddled with the history of the bilateral exchange rate, which means that fixing $/CNY weaker is not as easy as it sounds. This matters for global markets because previous episodes when $/CNY has fixed materially higher have seen the SPX fall sharply within one to two weeks... 

 

 

... with the DAX and NKY marching in lock-step (Exhibit 4). With the Fed approaching another hike over the summer (our US team puts a 70 percent probability on this), the risk of a repeat is growing, which via financial conditions could then loop back into US monetary policy.

Which brings us to what may be the biggest topic of 2015: the collapse in China's FX reserves, something which Goldman believes is about to be repeated:

From the perspective of China’s policy makers, there is an implicit trade-off between the pace of reserve losses and keeping the exchange rate stable in trade-weighted terms. By way of illustration, capital outflows during the first quarter were -$155bn according to the balance of payments, so that they could amount to -$600bn for the year. Even allowing for continued improvement in the current account, this means that reserve losses could run between -$200bn and -$300bn this year and next, after reserve losses of -$343bn in 2015.

 

 

We remain in the camp that the level of China’s reserves (currently around $3,200bn) is more than sufficient to deal with this pace of drawdown, but – realistically speaking – we see a good chance that markets will again speculate over the need for a one-off devaluation, even if the message from policy makers has been that this is not on the cards.

Essentially, what Goldman is saying is that the same "risk off" wave that followed the sharp devaluation episodes of mid and late-2015 is about to return, even though so far the market has been largely sanguine as it still does not really believe that the Fed will follow through with another hike.

Which brings up to the topic of Goldman's monetary policy "doom loop", which carries an uncanny resemblance to the "nightmarish merry go round" chart shown top. To wit:

The Fed remains a wild card in all of this. Our base case has been that some tightening in financial conditions, including via the Dollar, is needed to offset strong underlying momentum in growth and inflation. But if financial conditions tighten again on an SPX fall, there is a risk the Fed could again shift dovish, in what we are calling the “RMB-FOMC Monetary Policy Loop,” an implicit recognition that US monetary policy has spillovers to China, which is struggling with the legacy of its bilateral exchange rate peg to the Dollar. The sensitivity of the SPX to RMB weakness is thus something of a stabilizer for the Dollar bloc, potentially preventing the Fed from moving too quickly. That said, our base case remains that the US economy is strong enough to withstand a tightening cycle that will take the Fed funds target to 3.4 percent in Q3 2019.

And the chart.

 

And there you have it: Goldman just went bearish on the one currency which can destabilize the entire house of cards.

Which begs the question: is Goldman then quietly selling the USD and buying the Yuan, as it is has an alleged tendency of doing by frontrunning its clients... or is its reco genuine this time, and is actually seeking to cause the risk off avalanche. Recall that over the past month, Goldman has gotten both tactically and strategically bearish. It just needed the spark to unleash the fall. By telling clients to sell the Yuan, it may have just found it.