There are trade wars, and there are currency wars. Trade wars have the potential to negatively affect economic growth and earnings, prompting an equity market correction. Currency war tentacles stretch into the credit markets with their potential to trigger for downgrades and defaults. The yuan plunged earlier this week to its weakest point in over a decade, falling below the psychologically important 7 CNY/USD level. The currency’s one-day move was stunning, catching investors off balance. After a 24-hour respite, yuan weakness continued this morning. Washington accused China of currency manipulation. Though Beijing could have been accused of keeping their currency artificially weak in the past, nowadays the People’s Bank of China is in fact busy supporting the yuan, fearing capital flight.
Cresset does not believe we’re in a currency war, nor do we believe we’re entering one. However, the spillover effect of a weak CNY/strong USD is beginning to splash into the bond market. The yield on the benchmark 10-year Treasury note, at 1.6%, is off nearly a quarter of a percentage point since last Friday, reflecting prospects of lower global growth. The yield differential between the 10-year note and 3-month bills, which went positive after the Fed lowered rates last week, slipped back into inversion in response to the escalating trade war this week.
The Wall Street Journal recently reported that Chinese non-financial companies owe $800 billion in dollar-denominated debt. Chinese banks, meanwhile, carry $670 billion in dollar debt obligations. A weaker yuan makes repaying that debt more expensive, and potentially difficult. Dollar strength also puts pressure on commodities as well as global currencies and economies, particularly those with high USD debt balances. Credit conditions here at home are tightening incrementally and bear further watching. Corporate and municipal credit spreads have widened in recent days but remain within the third or fourth quintiles of their 10-year historical ranges. The Financial Conditions Index, an amalgam of US and international credit indicators which has moved in lockstep with large caps over the last several months, fell in recent days and has created a gap that has not yet been fully reflected in equities. Should this cozy correlation remain intact, it suggests near-term equity market vulnerability if financial conditions don’t improve.