$/CNY was one of the most important market drivers of 2H 2015. When China weakened its currency in August 2015, it sent shockwaves around the globe with the S&P 500 index falling 10%. In the third quarter of 2016, $/CNY stayed range-bound between 6.6 and 6.7. In October, however, the depreciation resumed and $/CNY is now approaching 6.8.
The recent CNY depreciation is different from previous rounds of $/CNY moving higher. It has not generated the same international spillover effects as it did back in 2015. This implies further room for the Chinese government to weaken its currency against the US Dollar without negatively affecting global demand for its exports. On the other hand, the link between $/CNY and capital outflows remains strong. Our China Economics team estimated that FX outflows from China rose to US$78 billion in September and are likely to be even higher in October (Exhibit 7). This implies that there is an underlying desire among onshore investors to move into dollar-linked assets. Such desire may become particularly strong whenever the pace of CNY depreciation picks up. In fact, onshore commodities prices increased across the board on October 25 after the $/CNY moved higher for three consecutive days.
There are reasons why iron ore may be the first in line to benefit from onshore investment flows into commodities amidst renewed CNY depreciation. For example, the iron ore futures curve is almost always backwardated, making long iron ore a positive-carry trade. To the extent that a higher $/CNY also leads to a weaker local currency on a trade-weighted basis, iron ore may benefit from potentially higher Chinese steel exports. Additionally, rebar and iron ore are the most traded commodities in the onshore futures exchanges. Exhibit 8 shows the positive correlation between iron ore futures trading volumes and the $/CNY in recent months. By our estimates, about 60% of the iron ore price rally in October can be explained by the CNY depreciation.
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If the correlation between the appreciation in iron-ore prices and the deprecation of the Renminbi are indeed causal rather than coincidental that could continue to be positive for commodity prices considering how much a weak currency benefits China’s economy.
The major iron-ore miners bounced today on improving sentiment regarding the US election. BHP Billiton’s reaction was relatively similar sized to that posted in August and a sustained move below 1150p would now be required to question medium-term scope for continued upside.
Rio Tinto continues to outperform and also bounced rather impressively today, with its most recent short-term higher reaction low in the region of 2650p.
Vale broke to a new high on today’s news to reassert demand dominance.