For Currencies, It's All About China

All of the major currencies traded sharply lower Wednesday against the U.S. dollar and Japanese Yen. With no U.S. data released over the last 24 hours, the moves in the FX market were driven exclusively by concerns about China. Unfortunately, the health of the world's second largest economy should continue to dominate FX flows over the next 24 hours. The big story Wednesday was the build up of bad loans in China as the manufacturing sector came in to focus with the HSBC flash manufacturing sector PMI report scheduled for release. Economists are looking for a minor improvement and if they are right, AUD could resume its rise. However if the data is weak, the losses for the AUD and other high beta currencies could compound quickly. There's U.S. data on the calendar but they should take a backseat to Chinese data and its impact on risk appetite. Investors have become immune to the improvements in jobless claims and U.S. trade numbers tend to be stale.

High beta currencies suffered and safe haven currencies performed well on the news that China wrote off three times more bad loans in the first half of the year. Investors are looking at the increase as a big red flag for Asia's largest economy and while it reveals some of the country's deeper problems, the write-offs are also part of the new government's overall strategy to clean up their books and bring default ratios to international standards. Instead, we believe that the sell-off in risk should be blamed on the People's Bank of China's decision to pass on injecting liquidity into the financial system for the second time since July 30. The central bank generally injects liquidity twice a week but a surge in capital flows last month has discouraged them from doing so this week. As a result, the seven-day repo rate surged more than 100bp overnight to a high of 4.5% before settling at 4.05% on the day. Tighter liquidity at a time when the world is watching the pace of Chinese growth carefully has weighed heavily on Asian stocks, risk appetite and high beta currencies.

However with the record profitability of some of China's largest lenders, now is the right time for them to take write-downs because profits can still be preserved and a deep sell-off in Chinese stocks avoided. There is no doubt that slower growth has increased the amount of bankruptcies and failed businesses in China but the government is also pressuring its banks to take write offs now to avoid a surge in non-performing loans later. At the end of the day, this process will help to make Chinese banks healthier but in the near term, if Chinese banks set aside more funds to write off bad debt, it would also reduce liquidity, an outcome that would not be kind to high beta currencies.

EUR: All Eyes On Euro Zone PMIs
The euro ended the day unchanged against the U.S. dollar, which is notable considering the steep slide in other major currencies. Its resilience is driven by the hope that euro-zone data will continue to surprise to the upside. Euro zone PMI numbers are scheduled for release Thursday and economists are looking for an uptick in economic activity. With the two major U.S. dollar risks behind us for the time being (fiscal crisis and 2013 tapering), relative growth has taken on increased importance for the EUR/USD. If euro-zone data surprises to the upside, investors will start to consider a neutral and less dovish stance for the ECB. Given the sharp rise in the expectations component of the ZEW survey, we would not be surprised if the euro-zone recovery gained momentum but the central bank's caution should not be taken lightly because there are many vulnerabilities in the euro-zone economy. The big story for the EUR/USD was ECB President Draghi's comment that they won't hesitate to fail banks in next year's stress tests. The central bank released its methodology for reviewing asset quality and as expected, the capital requirement for banks will be 8%, which most currently exceed. However if they fail to meet these requirements, "they have to fail, there's no question about that" according to Draghi.

GBP: BoE Upgrades GDP Forecasts, Slight Optimism The Bank of England minutes provided no support to the British pound, which traded lower against the U.S. dollar and euro. The decision to leave interest rates and the size of their Quantitative Easing program unchanged this month was unanimous but the minutes were slightly more optimistic. The Monetary Policy Committee has grown more positive on the sustainability of the U.K. recovery. They said the unemployment rate could fall faster than anticipated, boosting speculation that the first rate hike will occur in 2015 instead of 2016, as the Bank signaled in August. The central bank also raised its growth forecast to "around 0.7% a quarter or a little higher," which is "stronger than expected at the time of the August Inflation Report." This suggests that the central bank will also be boosting its GDP forecasts when the November Inflation Report is released. So while all members of the central bank felt that monetary policy should remain unchanged, on balance MPC officials grew less dovish which is a notable feat considering that the U.S. fiscal crisis at the beginning of the month posed a serious risks to the global economy. Given the central bank's more optimistic outlook, we continue to believe that sterling is poised for a recovery and a stronger move higher.

CAD: Bank Of Canada Drops Bias To Raise Rates
While risk aversion drove the Canadian, Australian and New Zealand dollars sharply lower against the greenback Wednesday, the Bank of Canada's monetary policy announcement also contributed to the move lower for the CAD. This morning, the BoC surprised the market by dropping its bias to raise interest rates, sending the Canadian dollar sharply lower. Their decision to leave rates unchanged at 1% was widely expected but their grim outlook for the economy caught many investors by surprise. By dropping the line that rates will need to be increased in the future and cutting their GDP forecasts for 2013, 2014 and 2015, the Bank of Canada is sending a very strong message to the market that they are worried about underperformance. The central bank sees a lower output level than previously projected with inflation risk escalating to the downside. The improvements that they were looking for in exports and investment have been delayed and as a result, there is sizable excess capacity in the economy. The BoC downgraded its forecasts for U.S. growth as well, which implies that their shift to a neutral bias is motivated by their concerns about growth inside and outside of their borders. Between the recent drop in oil prices and the Bank of Canada's less hawkish bias, we believe USD/CAD is poised to break 1.04. The Australian dollar also sold off aggressively despite stronger inflationary pressures. CPI rose 1.2% in the third quarter, three times faster than Q2. However the data did not have much impact on the currency because price pressures slowed on a year over year basis. Wednesday night's HSBC Chinese manufacturing PMI report was set to determine if the comm dollars are poised for further losses. Ahead of that report, investors were awaiting New Zealand's trade balance, which was expected to have improved significantly in September.

JPY Crosses Hit Hard By Chinese Banking Woes
The Japanese Yen traded sharply higher against all of the major currencies Wednesday on the news of massive write-offs in China's banking sector. With no economic reports released from Japan over the past 24 hours, risk aversion created new demand for the Yen. The worst performing Yen cross was NZD/JPY, which dropped more than 2% followed by CAD/JPY and AUD/JPY. This is a classic example of the impact of gravity on currencies because the pairs that rose the fastest are the ones that fell the sharpest. Japanese stocks were hit particularly hard by the news from China because Japan is largely seen as the proxy for Asia. USD/JPY in particular dropped to its lowest level in two weeks on the combined drag of weaker stock prices and lower Treasury yields. Looking ahead, the Yen pairs continue to be vulnerable with Nikkei futures pointing to a lower open. The Ministry of Finance's weekly portfolio flow report was scheduled for release Wednesday evening along with the Cabinet's Monthly Economic Report. Given the recent comments from Bank of Japan Kuroda, policymakers are confident that the current level of monetary stimulus is sufficient to stimulate the economy. As a result, the Cabinet's outlook for the economy is not expected to change. Therefore over the next 24 hours, the Yen will most likely trade on Chinese data.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.