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The Chinese revaluation had an instant galvanising effect on financial markets, at least until the news of the further attacks in London broke. The future on the Dow Jones Industrial Average jumped 61 points, European shares rose in tandem and the yen and the euro rose against the dollar. Bond prices fell.
That was a lot to happen on the back of a modest 2.1 per cent revaluation and a shift to a (yet to be detailed) currency basket. But it is not too difficult to unpick the reasoning. The revaluation is seen as lessening the competitive pressures on US and European businesses, hence the boost to equities. By shifting to a currency basket, the Chinese may have less need to accumulate dollar assets. That explains the boost to the yen and the euro, and also the bad news for government bonds, the latter also being hit by the perception that the devaluation was good news for global growth.
It is tempting to think that this reaction was overdone. A 2 per cent revaluation is unlikely to make any dent in the competitive advantage of the Chinese manufactured goods sector or have any impact on the US trade deficit. Of course, the Chinese move may lead to a more general Asian revaluation which will magnify the impact (Malaysia has already said it will switch to a currency basket). Even so, moves of a few per cent are small beer in relation to the world swings seen in the dollar/euro rate.
There may be some short term relief for the equity markets on the grounds that the shift will calm some of the protectionist pressures within the US Congress. But if the US-China trade deficit remains wide, that pressure will eventually resume. And the possibility of an extended bombing campaign in London may make investors nervous.
As for the bond markets, the Asian central banks will still need to buy US Treasuries, even if they have a basket, rather than a straight dollar link. But the move could have a psychological impact, in persuading investors that 10 year yields might indeed be too low, given the strength of the US economy and the likely direction of interest rates. Given that bond yields have already started to move higher in recent weeks, the Chinese move might just give the bond bears that vital ingredient: momentum.
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