Fed Cuts Could Send $1 Trillion FX ‘Avalanche’ to China, Jen Says

(Bloomberg) — Chinese companies could be drawn to sell a $1 trillion pile of dollar-denominated assets as the U.S. cuts interest rates, a move that could strengthen the yuan by as much as 10 percent, according to Stephen Jen .

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Eurizon chief executive SLJ Capital said the currency was now the biggest risk undervalued in the markets – and the yuan may play an exaggerated role.

“Think of an avalanche,” Jen said of the impact of repatriation flows. The yuan “will appreciate and will probably be allowed to – five to 10% would be modest and acceptable to China.”

The theory goes like this: Chinese firms may have raised more than $2 trillion since the pandemic in offshore investments, parked in assets that pay higher rates than those denominated in yuan, according to Jen. When the Federal Reserve lowers borrowing costs, the appeal of dollar assets will erode and potentially spur a “conservative” $1 trillion flow back home as China’s rate cut vis-à-vis the US tapers.

Jen, known for his work on the “dollar smile” theory, predicts that the Fed will cut interest rates more aggressively than markets expect if US prices continue to fall. This, along with an overvalued greenback, America’s twin deficits and the prospect of a soft landing, reinforces his belief that the dollar will fall.

The end result is a Chinese currency that could march higher against the greenback. It traded around 7.12 per dollar in the onshore market on Monday, as weak as nearly 7.28 in July.

The rally could be even bigger if the People’s Bank of China refrains from intervening to absorb dollar liquidity, London-based Jen said in an interview last week.

The case for yuan gains looks even stronger now, after Fed Chairman Jerome Powell said at the Jackson Hole Symposium on Friday that the time has come for the US to cut its policy rate.

However, such a move is unlikely to happen immediately after the Fed’s first rate cut. It can occur when the dollar’s declines accelerate amid a so-called soft landing scenario, or when inflation falls in the U.S. without triggering a recession, Jen said.

Yuan pressure

His view is in line with that of Guan Tao, a prominent economist at Bank of China International Ltd., who has argued that the yuan is at risk of rising if a scenario similar to the yen trade collapse plays out.

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The yen’s decline has been so great that it has spread across everything from equities to credit and emerging currencies. A collapse in the yuan-financed carry trade – which involves traders borrowing the currency cheaply and selling it against higher-yielding alternatives – could trigger fresh waves of panic, particularly in Asian markets.

Still, the PBOC can handle wild swings, Jen said. Beijing has always been wary of aggressive yuan gains as it can hurt export competitiveness and undermine an already slow economic recovery.

China’s foreign exchange watchdog is already on guard as it assesses the impact of a stronger yuan on exporters, people familiar with the matter said. And some strategists argued that trade deals centered around a weak yuan continue to make sense given China’s mixed economic fundamentals.

The PBOC also has plenty of measures to guide market expectations. Most recently, it has used tools to encourage currency stability, such as the daily benchmark rate for the onshore yuan and adjustments to the amount of foreign currency deposits banks must hold as reserves.

Also, with the spread between Chinese and US yields remaining wide, despite a gradual narrowing of late, corporates may not be selling their currency holdings anytime soon.

Others estimate the cash volume of Chinese companies to be somewhat less than the Yen.

Macquarie Group Ltd. estimates that Chinese exporters and multinationals have raised more than $500 billion by 2022. Australia & New Zealand Banking Group Ltd. puts the number at $430 billion.

“The pressure will be there” on the yuan to rally, Jen said. “If we just assume that half of that amount is money that is ‘storage’ and is easily challenged by changing market conditions and policies, then we are talking about $1 trillion worth of fast money that could be involved in a potential crisis.”

–With assistance from Qizi Sun.

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