Will China Scupper The USD Divergence Trade, Again? –

The scrapping of the so called circuit breakers used to arrest the slide of the China stock market and the firmer CNY fix overnight seemingly helped risk sentiment recover. This could only prove a temporary respite, however, and worries about the global economy could persist, fuelling risk aversion and making Fed’s job of hiking rates further more complicated. Indeed, contagion from the global markets has already weighed on US stocks, pushing our US financial conditions index to a multi-year high recently. Given that a spike in risk aversion forced the Fed to temporarily change tack and delay lift-off last September, the question for some investors now is whether a similar development could deal a blow to the USD decoupling trade at the start of 2016.

To start with, a look at various market sentiment measures would suggest that the investors are nowhere near as risk averse as last summer. Things could deteriorate quickly, however, if concerns about the global economy deepen (eg global trade is still slowing and domestic demand in many developed economies is still sluggish) and given lingering geopolitical risks. In the absence of further easing by the likes of the PBOC, the ECB and the BoJ, the onus may indeed fall on the Fed to prop up market risk sentiment yet again.

That said, we doubt that the Fed is on the verge of changing its policy stance anytime soon. What is more, given that the Fed cautiousness added to investors’ worries in September, we expect the FOMC to continue to signal confidence in the recovery, which should come across as relatively hawkish. We are sceptical that we are near the end of the USD divergence trade. 

More evidence that the US economy is recovering will likely limit any risk aversioninduced underperformance against the safe haven JPY or EUR. USD should continue to do well against smaller, risk-correlated currencies as well.