Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

China's surprise devaluation of its currency is widely credited with helping to trigger the swoon in stock markets in August.

If you're still looking for the magic formula that explains how a move of about 2 percent in the yuan can cause a more than 10 percent plunge in the S&P 500, well best of luck to you. Please report back with the equation once you find it, but we won't be waiting up for you. 

Roiling the Markets
Weakening the yuan by 2 percent in August caused significant ripples.
Source: Bloomberg

One thing's for sure, however: Don't be too surprised if a devaluation happens again. 

The consumer price index data just reported in the U.S. showed the strongest back-to-back increase in core inflation since April and May, pushing the Bloomberg Dollar Index to yet another record and pulling China's dollar-linked yuan along with it. All because the inflation data makes a December increase in the federal funds rate even more likely.

Handicapping the Fed
Futures trading shows a strong chance of a Federal Reserve rate increase next month.
Source: Bloomberg

David Tepper of Appaloosa Management told the Robin Hood Investor's Conference on Monday that the yuan is massively overvalued, Bloomberg reported, likely echoing the thoughts of many hedge-fund peers if not Donald Trump. The bears on the currency are circling as the real effective exchange rate is less than 1 percent from a record high. Let's just skip to the king of the bears, Societe Generale's strategist Albert Edwards, for the extreme case: He predicts China will let its currency weaken more than 20 percent within 18 months.  

Let's see, if we apply that equation where a 2 percent devaluation equals a 10 percent drop in the S&P 500, then by our math ... well, let's just hope Albert's wrong about this one, or that this elusive magic formula is wrong. Maybe both will prove to be wrong, but that doesn't mean stock-market investors should stop worrying about a potential devaluation of the yuan. Neither, however, should they necessarily fear a devaluation alone is worth another 10 percent slide. 

The 2 percent devaluation in August was widely regarded as not enough to cause serious damage to the U.S. economy. It did, however, require a recalculation of the prospects for every country that trades with China and made the world realize that the nation's currency peg is another potential lever China could pull to ensure a soft landing for its economy.   

It also was thrown like a rock in a pond into a U.S. equity market that had all but fallen asleep earlier in the year, with the S&P 500 trading in one of the tightest ranges in history. The ripples of volatility proved to be their own catalyst, likely exacerbating the declines in the market as various automated investment strategies predicated on assumptions about price moves and momentum recalibrated and sold stocks accordingly -- and various non-automated investment strategies predicated on irrational human emotions did the same.  

Since the markets have rebounded, short-term realized volatility has since subsided: 

Settling Down Short Term . . .
20-day realized volatility has retreated after August spasms.
Source: Bloomberg



While longer term historical volatility still reflects the spasms from August: 

. . . But Still Agitated Long Term
100-day volatility was still elevated after the summer meltdown.
Source: Bloomberg



Will the algos freak out again if China devalues while volatility shows the market is dozing off again? Hard to say. But for now, the humans are still vaguely in control and, as the remarks from Tepper and other players show, the market is less likely to get caught on the wrong foot this time.    

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net