CHINA MONEY WEEK: Higher China Stocks First Step To Yuan Rally

--Higher China Stocks Needed, But Not Sufficient For CNY Gains

By Stuart Allsopp

     SINGAPORE (MNI) - China stocks are trading near their strongest level

relative to U.S. stocks since early August and, based on the trends that have

defined 2018 so far, this should create downside risks for USDCNH. As we have

previously noted, however, Chinese equity outperformance is a necessary but not

sufficient condition for a sustainable yuan rally. 

     A reversal in equity performance needs to translate into a rise in Chinese

bond yields in order for the yuan to see a bullish reversal. We maintain our

view that equity outperformance is much more likely than yuan outperformance.

     --LACKLUSTRE RATE RECOVERY

     The recent sizeable outperformance in Chinese stocks relative to the U.S.

has failed to translate into a decline in U.S.-China interest rate swap spreads

and bond yields, with both US and Chinese rates heading lower. Expectations for

Fed hikes have been reined in, while expectations for further PBOC monetary

stimulus in the form of another RRR cut have risen, keeping the 2-year swap

spread near cycle highs.

     Furthermore, the recent U.S. equity weakness (together with the drop in oil

prices) has seen U.S. inflation expectations fall to year-to-date lows, keeping

upside pressure on real yields, while also putting upside pressure on EM CDS

spreads. China's 5-year CDS are trading near 18-month highs, undermining the

yuan's appeal.

     --HAWKISH PBOC SHIFT NEEDED

     In the face of these yuan headwinds, we would likely need to see a hawkish

shift in the PBOC's rhetoric in order for the yuan to outperform in line with

stocks. 

     So far, we have seen little sign of this from policymakers, but with

expectation of further monetary easing becoming entrenched and pessimism over

U.S.-China trade relations still elevated, a positive surprise at the G20

meeting between presidents Trump and Xi could provide a trigger for a hawkish

shift relative to expectations.

     That said, we continue to see the risk-reward trade-off of being long

Chinese equities relative to the U.S. as being a far better option to being long

the yuan, given the huge equity valuation advantage and the elevated level of

U.S. real interest rates.

--MNI Singapore Bureau; +65 8233 2326; email: Asia-Editor@marketnews.com

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