Euro rally indicates Euro area not immune to PBoC's devluation

The PBOC raised the official reference point for the renminbi from 6.1162 to 6.2298 on Tuesday, the biggest move since 1994. The bank increased the fixing again on Wednesday to 6.3306, bringing the devaluation to 3.5% over two days.  On Thursday, the PBOC devalued its currency for the third consecutive day setting the USD/CNY fix at 6.401, 1.1% higher than the previous fix. 

This may not be the end of it until Chinese officials have confidence that the economy is stabilising. Latest data points suggest that is not the case (China's growth is weak, period). A cut in the RRR could also follow. However, PBOC's Yi Gang briefing on the yuan today came in as respite to the markets, where he stated that further depreciation in the domestic currency is unlikely. 

The devaluation of the renminbi has buoyed the euro against most of its major G10 and EM counterparts. The single currency is up between 2% and 4% over the past two days against Asian currencies (CNY, KRW, MYR, etc). To what extent the EUR will rally further from here depends essentially at what pace China lets the renminbi fall even more, and what the Fed does with interest rates. Further disappointment from the Chinese economy is likely to bring more euro gains in particular against Asia. 

"The CNY depreciation has hit Asia ex. Japan (AXJ) currencies hard and is also impacting major currencies particularly EUR. This is understandable as the market is factoring in a declining likelihood of the Fed beginning its rate hiking cycle. This could drive further EUR/USD gains near term" said Danske Bank in a note to its clients.

The chart above shows the strong pace of appreciation of the REER (and CNY/EUR) relative to CNY/USD which was one of the factors cited by the PBoC for the regime shift on the currency. The CNY is down 4% against the EUR and 3.2% against the JPY over the past two days. Societe Generale raises USD/CNY year-end forecast to 6.60 from 6.22. 

EUR/USD rallied above 1.1150 and is capitalising in part on doubts that the Fed will raise interest rates in September. The sharp fall in US bond yields has led to a narrowing in US/EU 2y swap differentials to 80bp (-8bp since NFP last Friday). Incoming US data may not materially change the US backdrop between now and the FOMC meeting on 17 September, but a potential worsening by then of EM market turbulence (capital outflows), a rise in risk aversion (S&P through the 200dma of 2,075), and falling inflation expectations (5y down to 1.30% from 1.60% a month ago) will raise the bar for a Fed hike next month. 

The compression in US/EU rate differentials in the front end will continue if the Fed delays a first rate increase. EUR/USD is destined to retest the June highs (1.1436) if 1.1216/78 resistance is overcome. For EUR/GBP, a break of 0.7234 stands in the way of a return to 0.7400 (BoE still hawkish?). Eurodollar futures are pricing in a less than 40% probability of a 25bp hike in September compared to 64% after US NFP last Friday.