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0 Jun 23 2010 @ 10:57am by Matt Smith in Crude Oil, Global Energy, risk management

The euro’s the one, and not the yuan.

The euro and the yuan = the Sonny and Cher of the currency markets

After the fireworks and celebrations in the streets that followed the announcement that the yuan is set to be unpegged from the US dollar to float freely, the initial excitement, like the bubbly, has now lost its fizz. What initially appeared as a selfless act of cooperation and compromise by China, has morphed into the realization that this announcement was just a mere gesture by them to avoid getting flame-grilled at this week’s G20 meeting about their position as ‘currency manipulator in chief’. While this move into the limelight firmly positions the yuan as the sexy currency du jour (à la Cher), one of its currency counterparts – the euro – is considered much less attractive (sorry, Sonny). But nonetheless, I’m backing Mr Bono (= the euro) to have a bigger influence over financial markets in the coming months, and specifically, over commodityworld(tm).

Let’s take a step back. So, what’s the big deal about letting the yuan float? It is this: China has pegged their currency to the US dollar for the past few years, which has meant their exporters (a huge driver of their economy) have been charging the world artificially deflated prices for their goods. Good if you are a Chinese exporter and good if you are a purchaser of Chinese goods; bad if you are a producer of competing goods. Unfortunately, most of the world, and especially the US and Europe, are net purchasers of Chinese goods, meaning the undervalued yuan has allowed Chinese producers to undercut domestic producers of similar goods.

Yuan renminbi vs US dollar, March 2009 - present

Letting the yuan float means it will likely strengthen versus other currencies (since it was considered artificially pegged at a low level).  

A strengthening yuan would be good for the global economy because it would make Chinese goods more expensive, hence increasing the competitiveness of other countries, and promoting the rebalancing of those economies with striking trade imbalances (notably, the US) . It should also calm inflationary fears and ease concerns of a housing bubble in China, as a strengthening yuan would be the equivalent of a bucket of cold water on the economy. However, it is more likely that China would let their currency float because they believe their economy is strong enough to be supported by domestic demand, or because of the benefits that an improved purchasing power (from a strengthening currency) gives them in buying goods internationally. Or, alternatively, they think their currency will weaken (it would be hilariously ironic if it did, but isn’t beyond the realms…).

Then what’s the big deal about the euro?
The euro is the official currency of 16 Eurozone countries. What started out as an attempt to build a superpower strong enough to rival the economic power of the US back in 1999 has ended up turning ever more sour in recent months. The weakest links in the Eurozone chain (= PIIGS) are dragging down the strongest countries in the Eurozone, as waning confidence in the collective currency is causing its devaluation. The chart below is a great illustration of the decoupling seen in the euro at the beginning of the year. While the euro tracked risk appetite during 2009, following a similar path to equities and crude oil (as an inverted flight from safety caused the dollar to weaken and funds to flow into the euro and other risk assets), the considerable sovereign default risks that countries like Greece and Spain are facing have caused a massive move out of the euro, and hence its rate versus the dollar to fall. Drawing this back to commodityworld(tm), and specifically crude, the two have become reacquainted in the past two months, and as the euro has had a relief rally in recent weeks, so have risk assets. Going forward over the next few months, the Eurozone is likely to face further and increasing default risks, which can only have a detrimental effect on the euro, and risk generally. This puts headwinds against crude oil advancing at a strong pace, regardless of the decoupling seen earlier in the year:  

Maybe I am being too cynical here; perhaps this move by China’s policymakers is a clear signal that they are willing to cooperate with the global financial community. Yet for all of the furor that the announcement has made, there has been little evidence that it will have a dramatic impact on markets (and hence commodities), in the short term at least. In the meantime, the bigger influence on commodities, and specifically crude oil, is more likely to come from the euro, which should come under further selling pressure as it struggles to find the cure for the economic illnesses infecting a number of its member-nations. As for how this will play out over the long term? We don’t know. And we won’t find out until we grow.

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