Global market impacts
A chill from China
The conventional adage in international economics has long been that when the United States sneezes, the rest of the world catches a cold. The U.S. economy has been so dominant relative to the rest of the world, that the fits and starts in America's real economy and monetary policy affected markets all over the world and created the backdrop against which policymakers in other countries made their decisions.
While the U.S. is still the largest economy in the world, the third quarter of 2015 showed that there is another player equally capable of spreading contagion to the world economy: China. The Middle Kingdom's deceleration from a decade of rapid growth has had a depressing effect on various markets since the bursting of its property bubble last year. This summer, a pair of market shocks stemming from China jolted markets around the world and complicated the Federal Reserve's (Fed's) deliberations about raising interest rates for the first time in nearly a decade.
As the third quarter began, however, China's problems hovered in the background. There was a crisis in a much different corner of the world that seemed likely to upend the stability of global markets and confound summer plans for millions of investors.
Greece's increasingly contentious negotiations with its European institutional lenders came to a head in early July. Prime Minister Alexis Tsipras, leader of the anti-austerity Syriza party, surprised Eurozone leaders by calling a snap referendum for July 5 over the arduous terms lenders were demanding for a third bailout. The call effectively pushed negotiations past a June 30 deadline, which led the European Central Bank (ECB) to restrict emergency funding to the Greek financial system. Athens was forced to declare a bank holiday. Cash withdrawals from ATMs were limited to 60 euros per day, and international transactions were banned. Greece's already failing economy suffered increased harm.
When the vote returned with a resounding "no" to further austerity, the negotiations were thrown into disarray. The possibility of Greece's exit from the Eurozone, and the impact that would have on the single currency and the underlying economies, again swept through markets and commentaries.
However, the poll was an exercise in futility: Despite the "no" vote, Tsipras was forced by events to make concessions he would not or could not make before. By July 13, Athens had agreed to a framework that gave Greece access to emergency funding, and, contingent on early reforms of its tax and pension rules, opened the door for a third bailout. The International Monetary Fund (IMF), which had remained aloof during the negotiations, offered Athens a fig leaf when it declared that Greece's debt situation had deteriorated during the spring and now was "unsustainable." The IMF indicated that a politically difficult element of debt relief or restructuring would be necessary for the long-term viability of the Greek economy.
Throughout the latest act of the Greek debt drama, implied volatilities in the currency market ? particularly for euros and U.S. dollars ? were elevated, with put-call preference markedly favoring euro puts. The spot price, however, remained within a fairly narrow range, trading between 1.1150 and 1.0850, and avoided a decline to the lows touched earlier in the spring. Despite the implications from the options market, the broader foreign exchange market seemed to be holding a wait-and-see attitude about the Greek crisis, and gradually pushed the euro up after its denouement
Testing the Chinese authorities
Meanwhile, as the financial world was transfixed by the dramatic developments in Europe, China's equity markets collapsed. After having run up by nearly 60% since the beginning of the year, the Shanghai Composite Index fell 32% between June 15 and July 8. The rise and fall of the Shenzhen Index was even more dramatic: Up 120% and down 40% in the same period.
By and large, the international reaction was muted. China's economy is not driven by equity financing near to the extent that it is in Western countries, and the principal anticipated effect of the stock declines was to the detriment of individual speculators who bought stocks on margin.
However, the large declines telegraphed a warning about the Chinese economy that would soon become clear: The slowdown was continuing and getting worse. More problematic, perhaps, was the impression that Beijing was floundering in its response to the sudden market declines. Authorities issued a series of moves to stem the stock market decline ? cutting reserve ratios, banning initial public offerings (IPOs), restricting selling, and ordering government-linked brokers and agencies to buy stocks ? that gave the impression of ad-hoc reactiveness. Worse yet, the moves appeared unable at first to stem the market declines. This undermined Premier Xi's efforts to bring China's financial system up to the developed world's standards of openness and transparency, and, paradoxically, undermined the Chinese public's confidence in Beijing's ability to manage market forces.
Beijing gave the market ? and its reputation ? another jolt in mid-August, when it reversed years of steadily managed appreciation of the yuan and set the midrates 2% weaker for trading on August 11. China couched the change in terms of making the currency more responsive to market developments, saying market prices would be the main factor in future daily settings. In the past, the Bank of China would set rates according to policy objectives with little regard for market pressures. Despite the claims, the market saw the devaluation as an emergency response to a rapidly slowing economy.
Within two days, the offshore yuan had fallen more than 6% before stabilizing more than 4.2% weaker than before the devaluation. As the quarter progressed, Chinese authorities vigorously supported the yuan, preventing further decline. But daily trading ranges were a multiple of the narrow ranges prevailing for the four months preceding the move. Option volatilities leaped, with prices strongly favoring U.S. dollar calls, and liquidity suffered as traders waited for the market to settle down.
Echoes around the world
Confirmation of China's slowdown followed quickly, and world markets reacted badly. Within days, Beijing reported disappointing industrial production and retail sales figures, followed by the weakest (PMI) reading since the depths of the global recession in 2009. Equity markets already in decline fell dramatically, with the U.S. market down 10% in a matter of days. Similar deterioration occurred in London; Frankfurt; Paris; Tokyo; Toronto; Melbourne, Australia; Mexico City; Sao Paolo; and elsewhere. The Shanghai Index, after recovering during July, fell another 25%.
Commodity markets suffered similar declines. Steel, coal, copper, and crude oil, all of which had declined by 25% or more just since May, spiked downward as the financial turbulence rippled outward. Fixed income markets, on the other hand, split. Bonds rose in safe-haven markets, such as the U.S., U.K., Germany, and Japan. Those countries vulnerable to China's slowdown and its impact on commodity prices, such as Canada, Australia, Mexico, and Brazil, saw declines in their bond markets alongside the selloff in equities.
Amid world currencies, the dollar failed for once to play its usual safe-haven role. The trade-weighted U.S. Dollar Index (DXY) fell 3.1% in three days. Investors instead bought yen, euros, and Swiss francs, which gained 4.4%, 4.9%, and 3.7% in a matter of days.
Currencies of commodity exporting countries continued and accelerated year-long downtrends. The Australian and Canadian dollars, along with most Latin American and Asian currencies, have suffered from the retrenchment in China's imports and reached new multiyear lows on August 24. In Australia, the economic impact led to a party leadership challenge, and subsequently a new Prime Minister. In Brazil, the decline is compounded by a long-running political crisis, and the Brazilian real (BRL) has lost more than 50% of its value since year-end.
As if to underscore the problem, Beijing reported that imports in August were down 13.8% versus the prior year. In late September, the city announced that the manufacturing PMI had fallen to a new cycle low.
Meanwhile, back at the Fed
The disruption and volatility that followed China's devaluation and stock declines became a factor in the U.S. Federal Reserve's decision on whether to raise interest rates. Before the devaluation, opinion was divided but favored the odds of the Fed raising rates at its September meeting. The domestic U.S. economy was showing signs of sustainable growth, particularly supported by consumer spending and improvements in the job market. Weighing against the rate rise was underperformance in the manufacturing and export sectors of the economy, as well as the fact that the decline in energy prices and the strong U.S. dollar kept inflation very subdued.
Financial markets were especially keyed to the September meeting, as that had been cited by several Fed spokespersons over previous months as a potential if not likely time for the central bank to depart from the near-zero stance it has held for nearly seven years. However, in the wake of the summer tumult, observers gradually modified their expectations ? guided by various Fed speakers ? so that by the time of the September announcement, the odds had turned toward further deferral.
In the end, Federal Reserve Board Chair Janet Yellen elected to leave rates unchanged and left markets uncertain about future plans. In both the published statement and the post-decision press conference, Chairwoman Yellen cited heightened uncertainties abroad as reason for caution. Subsequent remarks, including from the chair herself, suggested that absent the international outlook, the decision would have been to start "liftoff." Thus, did the coughing from China give the Fed a case of the chills?
The market reaction to the Fed's deferral was a short-lived relief rally. Currencies strengthened against the dollar, emerging country equities markets rallied and bond rates declined. Almost immediately, however, the market focused on the Fed's apparent anxiety about a worldwide economic slowdown, and the earlier trends reasserted themselves. By quarter's end, global equities, commodities, developed country bond yields, and emerging and commodity-based currencies were all lower than before the announcement.
As if closing out the quarter by design, focus swiveled back to Greece at the end of September, where Greeks returned to the polls for a third time this year. The snap election, called when Prime Minister Tsipras resigned in the wake of the July agreement, occasioned little of the earlier tension as opposition to austerity seemed exhausted. The outcome held an almost-theatrical irony: Tsipras was returned to office to implement the austerity measures he had fought so hard to resist.
At the same time, long-term restructuring of Greece's debt load remains an outstanding issue, strongly suggesting that the Greek drama is likely to return to center stage some time down the road.
Fred Stambaugh is a senior vice president and senior options specialist for the Wells Fargo Foreign Exchange Risk Management Group. He is based in San Francisco and can be reached at firstname.lastname@example.org.
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