The Market Thinks China's Currency Policy Drives U.S. Monetary Policy
The turmoil in global equities to kick off the year might not be all China's fault.
But the relationship between Chinese currency volatility and the eurodollar curve—a set of futures contracts that track the expected yield on three-month U.S. dollar deposits held abroad—suggests that the exchange rate policy in the world's second-largest economy is influencing market expectations of monetary policy in the world's biggest economy, according to analysts at Credit Suisse.
"There has been a strong correlation recently between Chinese currency volatility and flattening in the front end of the U.S. curve," writes Helen Haworth, managing director of global interest rate strategy, referring to the increase in volatility of the offshore yuan implied by options markets and a reduction in expectations of how high the Fed's policy rate will go. "Sustained disruption from China is likely to lead to easier monetary policy globally as a result of its implications for global growth and inflation."
Eurodollar futures are increasingly at odds with the Federal Reserve's dot plot, which details each policymaker's preferred trajectory for interest rates, amid Chinese currency weakness and uncertainty about how Beijing will manage the yuan. The market's limited expectations for the speed and magnitude of the tightening cycle are "clearly in policy error territory," according to Haworth.
Financial market carnage stemming from the devaluation of the yuan in August stayed the Fed's hand at its September meeting, with monetary policymakers indicating that the downdraft "may restrain economic activity somewhat."
Market participants, it seems, are of the opinion that lightning will strike twice. Credit Suisse, however, cautioned that there's still plenty of time for the situation to be resolved as a prelude to a hike—as was the case in the runup to liftoff in December.
"With still two months left to the March FOMC [meeting], there is time for financial conditions to settle, and if combined with strong data, we think there is still potential for a repricing in U.S. rates, but the bar to such a move has been raised," concludes Haworth.