The Yuan Announcement and Market Reactions

This morning's dominant piece of news for financial markets is China's announcement over the weekend that it would adopt a "more flexible" exchange rate policy with the yuan. As a result, commodities and equities are rallying, on the rationale, that the likely appreciation of the yuan will lead to stronger economic growth in the U.S. (and, therefore, stronger corporate profits and demand for commodities), while the bond market is, predictably, taking a hit.

As an initial, broad, assessment of the significance of the move on the yuan, the front page article in today's WSJ ("China Eases Currency peg) is a reasonably adequate one. However, in evaluating the financial markets' reaction to the news, and the sustainability of this morning's price dynamic, some perspective is desperately required.

Despite this morning's fairly substantial rise, by nearly 0.5%, of the yuan against the dollar, the pace of further appreciation is likely to proceed very slowly, with the likely total amount of such appreciation by year end probably limited to the 4% to 5% range. Such a tightly controlled pace of the yuan's rise over the next six months or so is likely to be mostly due to two factors: a) The strong influence of the export lobby in China that will strenuously resist a more substantial pace of appreciation, particularly in an environment where their main export markets are growing at a very unimpressive pace, and b) The fact that the yuan is going to be managed against a basket of currencies, with the euro being one of its key components; if the euro's recent weakness persists, then the rise of the yuan against the dollar will have to be very limited to offset its potential further rise against the euro within the basket.

Against that backdrop, it is hard to imagine the prospect of a more flexible yuan policy ahead, which will probably lead to a further moderate appreciation next year, becoming a game-changer for the outlook of the U.S. economy over the next 12 to 18 months. Actually, the manufacturing sector, which is presumably the sector of the U.S. economy likely to benefit the most by a stronger yuan, has been doing particularly well in the last 9 months, having already become a key driving force of the economic recovery.

But the problem is not the manufacturing sector. The key challenges for the U.S. recovery over the medium-term include a still cautious pace of job creation, tight bank lending standards, any ripple effect from the fiscal turmoil in the eurozone, and the lingering drag from the housing market meltdown. Potentially stronger exports to China over that time frame are not likely to materially alter the outlook for economic growth in the U.S.

As a result, it is questionable whether the stock market's enthusiasm generated by the yuan announcement over the weekend will have long enough legs- that is, beyond a matter of a few days- to sustain a powerful rally in equity prices. It will not be before long when both equities and Treasuries refocus on the underlying realities permeating the current economic environment.

The prospect of only a cautiously optimistic FOMC statement on Wednesday -a reminder that the economic environment is still confronting a number of headwinds-, uneven economic data (with the emphasis on this week's struggling initial claims series and the magnitude of the likely decline in May's durable goods orders) may help put a brake on the stock market rally and the slide in Treasuries by the end of the week.

Anthony Karydakis