Jeppe Ladekarl
June 30, 2020

The Chinese government has moved to introduce measures to assert greater control over Hong Kong, virtually ending the "one country, two systems" agreement 27 years early. While the recent re-start of protest in Hong Kong could be the primary driver of the new security measures, it's hard not to think a broader effort is underway - and not only in Hong Kong - as most countries are occupied with other urgent issues, and have little desire to engage in a fight with teeth. That goes not only for the US, but also the European Union and the old colonial power of Great Britain.

While other governments have issued statements, the reaction thus far has been essentially all bark and no bite.  Specifically, responses from the US and others seems likely to be limited to rhetoric and regulation with new tariffs that will minimally impact trade (if at all).  Currently, the financial market interpretation is that the event will have little direct impact on asset prices or implied volatilities.  The Hang Seng Index was down in May but not in freefall, showing a fairly benign market reaction.  On the other hand, there are some indications that substantial buying from mainland China has impacted the Hang Seng Index, which may mask the degree to which the event is affecting the market.

A better way to judge the current temperature of the market is to look at currency moves, which may offer early indications of more dramatic spillovers into global risk assets.  Below are three moves to consider: the Chinese yuan against the USD (USDCNY); the spreads between the yuan traded on-shore and offshore (CNY versus CNH); and, finally, the Hong Kong dollar itself.

The PBOC has fixed the USDCNY rate higher since the beginning of 2018, allowing the CNY to depreciate against the USD. Since then, the CNY’s downward move has not been dramatic and has generally followed the progress in the EURUSD. The first graph below shows both the EURUSD and the USDCNY.  (Note that the USDCNY on an inverted scale, as a higher number for the USDCNY reflects a weakening yuan.)  Lately, the USDCNY has been allowed to diverge from the EURUSD, as the euro has strengthened.  While the expectation is for modest, slow depreciation of the CNY, an acceleration of higher fixings for the CNY could be seen as a heightened worry from the Chinese authorities that the conflict is starting to have a real impact on trade and sending a subtle but clear message to the US authorities that China has more ways than one to counter policy moves..


The on-shore/offshore yuan spread (the CNHCNY spread) is a gauge of speculative appetite offshore. The expectation is for the spread to be an effective canary in the coal mine for short-term changes in sentiment, both as a risk shock is starting as well as ending.  As of now, the spread looks well within its normal range.


Finally, the Hong Kong dollar (HKD) exchange rate itself is worth tracking for signs of broader stress. Since October 1983, the HKD has been pegged unilaterally to the USD at a level between $7.75 and $7.85. The HKD is currently toward the stronger side of the band, showing – at least outwardly – few signs of capital outflows from Hong Kong. Given Hong Kong’s foreign exchange reserves, the HKMA has the ability to keep the exchange rate pegged on the firm side. However, a move toward the upper end of the band would be another sign that pressure is mounting.


All in all, currency markets seem to be mimicking the marked indifference of direct equity market moves. Whether this indifference will remain is far from clear.  The tension between the US and China is here to stay. Both have interests, domestic and geopolitical, in continuing an adversarial course.  However, given the weakness in the global economy, both countries also have an interest in mitigating the impact on trade and the real economy. This will be a delicate balancing act, and the market’s current indifference is likely to be tested at some point.  As events unfold, the currency markets will be a good place to look for the Canary in the coal mine.


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