Yuan sell-off potential warning sign for risk

FX markets painted a somewhat bearish picture towards risk, while US equity index futures extended their gains at the start of the new week. But does the rebounding USD/CNH point to a potential sell-off for stocks later in the week?

For stocks, Monday has started how the markets ended on Friday, with European indices and US futures extending their gains. In commodities, crude oil fell more than 1% while gold and silver edged slightly lower. The US dollar fell against the yen but rose against the euro, commodity dollars and emerging market currencies. The yuan led the declines after the People’s Bank of China changed a rule that made it cheaper to short the Chinese currency.

So, the FX markets were painting a somewhat bearish picture towards risk, providing a warning for the racier equity market. The latter has been rising again over the past few weeks, mainly on hopes over the prospect for more fiscal stimulus from the US, as well as ongoing central bank support from the Fed and others. Expectations for additional government spending have also been pushing the dollar down against risk-sensitive currencies.

However, I just wonder whether there is much juice left in this risk rally. Stimulus hopes alone cannot support the markets every day, especially as even if the two sides come to an agreement there is little chance of getting legislation passed by Congress ahead of the election. So, it appears as though investors’ hopes of getting a large stimulus rests mainly on Joe Biden’s Democrats winning the election. But as we found out in the last election, the polls could be underestimating Trump’s chance of winning again.

Therefore, the uncertainty over the presidential election, as well as rising levels of COVID infections, means not all investors will buy the stimulus hope narrative. Indeed, hospitalization has started to climb again across many European countries and if deaths start to catch up with rising cases, then the possibility of further restriction measures and thereby concerns over the economic recovery will both increase. As a result, sentiment towards risk could turn decisively negative.

What’s more, we also have a good number of potentially market moving economic data releases this week, while a self-imposed deadline for Brexit talks for PM Boris Johnson is looming. Additionally, the third quarter US earnings season will start with results from the likes of JPMorgan, Citigroup, Goldman Sachs and Johnson & Johnson all due this week. So, there will be a lot happening, which could undermine risk.

With that in mind, I wanted to share the chart of the USD/CNH as part of this article. Even if you don’t trade this pair, it is worth watching it given that it is a good proxy of risk sentiment. Rates have been falling over the past few months as risk sentiment improved. Admittedly, today’s selling of the yuan may have been driven by the People’s Bank of China changing a rule that makes it cheaper to short the yuan. But the USD/CNH has now bounced sharply off key support around 6.6800 after an extended drop:
Source: ThinkMarkets and TradingView.com

Is this just an oversold bounce or a bottoming formation? Whatever it is, this pair needs to be monitored closely now. We need a higher high above 6.845 to confirm the potential reversal. At the time of writing the USD/CNH was testing key resistance around 6.7500, which meant it was possible the downtrend could resume from here. A daily close above 6.7500 or thereabouts, if seen, would be a bullish signal in the short-term, in my view.