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How Much More Faith In Central Banks Is Left?


Carry traders just got their fingers burnt by central bankers, again.

As Bloomberg reports,

The People’s Bank of China’s decision to cut its daily reference rate by 1.9 percent triggered the yuan’s biggest one-day drop since the nation ended a dual-currency system in January 1994. That’s bad news for carry traders, drawn to the yuan by its stability. Until Tuesday’s surprise move, the central bank kept it in a tight range of 6.1887 to 6.2205 against the dollar since the start of April, according to prices compiled by Bloomberg.



The PBOC’s decision is just the latest misfortune for these traders.


A Deutsche Bank index of carry trades had already dropped to 510.31 Monday, from 546.71 at the end of last year, after the Swiss National Bank ditched its exchange-rate cap in January, sending the franc soaring and wiping out returns.



“There are people who have seen the implausibility of China devaluing -- because they said they wanted stability -- as justifying owning the currency in one form or another, simply for carry,” said Kit Juckes, a London-based strategist at Societe Generale SA. “It’s another domino that has fallen.”


Investors in carry trades borrow in one currency to invest in another where interest rates are higher. They profit both from the rate differential and any appreciation in the purchased asset. Higher volatility can hurt returns because adverse price moves can wipe out the benefit from the pick-up in rates.

Twice in eight months is enough to shatter anyone's illusion that central banks really have control. But perhaps just as worrisome for the central-bank-omnipotence meme, is how last night's action was translated to the masses (as Epsilon Theory's Ben Hunt explains)

Everything under heaven is in chaos; the situation is excellent.
 ? Mao Zedong (1893 – 1976)


A quick email on China’s currency devaluation last night. The news itself is big enough, but it’s the Narrative that’s developing around the devaluation that has my risk antennae quivering like crazy. What do I mean? I mean that initial media efforts to portray the devaluation as a one-time “adjustment” that’s in-line with prior policy have been overrun by stories of “shock” and disjuncture. This is true even within Rupert Murdoch’s various media microphones, which tend strongly to toe the Beijing party line. Moreover, the devaluation is not being described in Western media as Chinese “stimulus”, which it surely is and would send markets higher if portrayed in this light, but as Chinese “currency competition” and as a sign that the growth problems in China are more severe than Western central bankers would like to believe. Or more precisely, would like to have YOU believe.


What’s the Truth with a capital T about Chinese growth, Fed intentions, and the future price of growth-sensitive assets like oil? I have no idea and neither does anyone else. Seriously.


But what I do know is that the Common Knowledge about Chinese growth – what everyone thinks that everyone thinks about Chinese growth – is dramatically changed for the worse today, and it’s a change that will accelerate unless the Narrative shifts. That could happen. I still have nightmares about how the Narrative around the ECB’s OMT program shifted from “Draghi’s Blunder” to “Draghi’s Bold Move” within a single day in the pages of the Financial Times in the summer of 2012. But unless and until that Narrative shifts, the path forward for the Fed just got much more perilous.


And that’s why the 10-year US Treasury is at 2.12% as I write this note. Unless and until that Narrative shifts, the path forward for oil and any other global growth-sensitive asset or security just got much more perilous. And that’s why oil is at $43 as I write this note. 


One last point, focused on what’s next for China. As with everything else here in the Golden Age of the Central Banker, my crystal ball is broken. But I think that I’ve got the right lens for viewing China and its political dynamics, and you can read about it in two Epsilon Theory notes: “The Dude Abides: China in the Golden Age of the Central Banker” and “Rosebud”.

As mentioned earlier this devaluation is likely not a one-time event but rather the beginning of an ongoing and persistent depreciation of the CNY versus the USD. The embedded USD short position within the carry trades will begin to result in losses and margin calls as the USD appreciates versus the CNY, thus forcing investors to liquidate some of their positions. These trades, which took years to amass, could unwind abruptly and exert an influence of historic magnitude on markets and economies.

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Change is afoot.