China Less Turbulent, For How Long? Event Risk Eyed - Analysts

Chinese equity and currency markets have been somewhat less turbulent since before the Lunar New Year holiday in early February and may remain so until after the National People's Congress, which begins later this week.

Nevertheless, global investors maintained their vigilance, uncertain if such calm can be sustained for long.

The Shanghai Composite closed up 4.26% at 2,849.68 Wednesday, after trading in a 2,782.539 to 2,852.700 range. At today's close, the index was down 19.5% year-to-date.

The index, which topped out on several occasions last week in the 2,925-2,935 range, fell to a low of 2,638.963 Monday, not far from the prior 2016 low of 2,638.302, seen Jan. 27, which was the lowest level since late November 2014.

A break above last week's peaks would suggest that a double-bottom was in place, at least in the near-term, and that would likely mean a test of the psychological 3,000 mark. The Shanghai Composite last closed above 3,000 on Jan. 19.

In currencies, the dollar versus the on-shore Chinese yuan closed at CNY6.5510 Wednesday, after trading in a CNY6.5501 to CNY6.5540 range

After firming yesterday, the Chinese yuan reverted back to the weakening trend that has prevailed recently.

Today's USDCNY high was the weakest yuan level since February 5, before the Chinese Lunar New Year holiday and in sharp contrast to the high yuan levels seen Feb. 15, when USDCNY posted a low of CNY6.4893, the lowest level since late December, and closed at CNY6.4962.

The USDCNY high of CNY6.5962, posted Jan. 8, 2016, was the highest level (lowest CNY level) seen since February 14, 2011 (CNY6.5980 high). The 2011 peak was CNY6.6369, seen January 10.

The PBOC intervened heavily January 12 in order to narrow the spread between the on-shore and off-shore yuan.

The first week in January, the CNH-CNY spread widened to as much as +1,400 pips, as speculators entered into CNH shorts on expectations of a higher USDCNY.

Subsequently, the spread between the CNH and CNY prices has narrowed substantially. The CNH-CNY spread at Wednesday's close was +31 pips, compared to -11 pips Tuesday.

Nick Bennenbroek, head of currency strategy at Wells Fargo, looked for only only modest yuan weakness over the medium term.

At the same time, he saw scope for FX volatility to persist "especially as the central bank's focus is shifting somewhat from focusing solely on the value of Chinese currency against the U.S. dollar, to assessing the value of the Chinese currency against a basket of currencies."

Wells Fargo's near-term outlook for the next three months "envisages the possibility of some renminbi strength, targeting a USD/CNY exchange rate of CNY6.5000," he said.

"Over the medium term, we expect only a moderate softening in the renminbi, targeting a USD/CNY exchange rate of CNY6.5900 in 12 months and CNY6.6500 in 18 months," Bennenbroek said.

Many analysts still looked for the on-shore yuan to weaken, and maintained their end of year forecasts closer to CNY6.80 or even CNY7.00 for USDCNY.

Looking ahead, Goldman Sachs strategists reminded that China's National People's Congress (NPC) convenes this week "to formalize policy targets and announce measures to further stabilize the economy."

In light of comments from senior Chinese policymakers at G20 last week, "which emphasized stability in growth and FX and intentions to continue economic reforms, the NPC will be an important barometer of the political determination to make large strides in these areas," they said.

"The key challenge here for the NPC will be to rein in some of the major imbalances in China's economy as well as the desire to pause, or at least slow, China's 'bumpy deceleration' in growth," Goldman said.

The National People's Congress begins its annual meeting Thursday. See MNI Main Wire at 3:37 am ET and 7:16 am ET for details.

Also on the market's radar screen will be the release of China's FX reserves for February, expected March 7.

As a reminder, last month the PBOC reported that China's FX reserves fell by $99.5 billion in January, as the PBOC sold dollars to prevent the yuan from sliding too far against amid persistent depreciation pressure

This was the second-largest reserve decline on record, after December's $107.9 billion drop, and took the reserves down to $3.23 trillion, the lowest since May 2012. Given the relative stability of the yuan in February, reserves were not expected to see such a sizable decline.

China still has a sizeable war chest to defend the yuan should it opt to do so, but many analysts point out that a few more months of $100 billion declines could see total reserves break below the $3 trillion mark, which would be deemed a psychological negative.

On the day, there was limited reaction to China's debt outlook being downgraded by Moody's Investors Services earlier.

Steve Barrow, head of G-10 strategy at Standard Bank, said while Moody's downgraded China's debt outlook, taking it to negative from stable, the rating agency also re-affirmed its current Aa3 rating; "the same as S&P and one notch higher than Fitch."

"Moody's cited things like the rise in debt and the difficulty of reform, alongside falling FX reserves," Barrow said.

He noted that the market largely shrugged off the ratings news.

"China is very much like Japan in the sense that credit ratings don't really impact the market because the vast bulk of debt is owned internally, not externally," he said.

While less in the limelight, analysts generally cheered the steps taken last week by the China to open its bond markets to foreign investors.

On February 24, the PBOC announced that it will allow all foreign institutional investors access the country's interbank bond market. This step, which took place immediately, was deemed as part of China's long-term strategy to open its markets to foreign investors and promote the yuan as a global reserve currency.

"As long as you are an institution that is not a hedge fund, you are welcome to trade in China's RMB 35 trillion interbank bond market," said Carl Weinberg, chief economist at High Frequency Economics in Valhalla, NY.

China's is the largest fixed income securities market after the U.S. and Japan, he reminded.

"Demand for these securities is going to be huge, because they are a near-perfect hedge to any portfolio," Weinberg said.

"Adding a yuan-denominated bond to a portfolio will increase the average yield of the portfolio, while further diversifying total risk," he said.

Using simple correlations between China's 10-year sovereign bonds and other major markets and comparing these to similar correlations for U.S. Treasuries, HFE found that "adding a 10-year Chinese government bond to a portfolio adds 112 basis points more yield than adding a U.S. Treasury, but its correlation ranges between 0.2 and 0.5 with all other markets, except JGBs."

Regarding risk, Weinberg said that all bonds have credit risk, adding that "currency conversion risk" is also a concern.

"Long-term investors will have to decide if they think the yuan is a surer long-term bet than the dollar or the euro, or at least equal to it," he said.

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