China Devalues its Currency

China’s devaluation puts the U.S. Federal Reserve in a bind.

Devalued Yuan is Dollar Negative Long Term.

A devalued Yuan should create more demand for Chinese products and use of the Yuan as an international transactional currency.

Should the U.S. follow China’s lead and devalue the dollar?

or should the Fed forge ahead with its rate hike plans?

China has devalued its currency – twice so far. The Fed was itching to raise rates (in our view to combat de-dollarization), to support the dollar and propagate the myth that the U.S. economy is strong, QE worked and treasury bonds are a safe haven place to park reserves, their value protected by the prudent stewardship of the Federal Reserve.

China’s devaluation of the Yuan interrupts the Fed’s long cited rate hike narrative.

While devaluation of the Yuan may make the dollar stronger initially and give the Fed pause in even thinking about raising rates, longer term, Yuan devaulation is dollar negative.

The dollar has been used increasingly less as an international transaction currency in recent years. With countries around the world opting to not use the dollar in trade among themselves, and with lower oil prices (requiring countries to keep lower dollar reserves in the form of U.S. Treasury bonds to buy oil), demand for the dollar as an international transactional currency has been falling.

Demand for U.S. Treasury bonds is also waning with Japan, China and Russia either halting their purchases or selling their holdings.

Russia has slashed its U.S. Treasury holdings as part of its de-dollarization strategy.

Lower Yuan = More Yuan-based Transactions

A lower Yuan may make it a less attractive place to park reserves. The Yuan, currently however, is not a reserve currency but an increasingly transactional one. A lower Yuan means Chinese goods will become cheaper and trading partners should see an increase in trade with China, meaning the Yuan will be used more with countries that already trade with China in Yuan and countries that don’t may be encouraged to do so as their trade with China increases. Thus, demand for the Yuan as a transactional currency will increase and demand for the dollar decrease.

The greater demand for a currency as a transactional vehicle, the greater the need to hold that currency as a reserve asset.

What are the Fed’s Options?

If the Fed wants U.S. products to remain competitive internationally it needs to consider not raising rates, which would further strengthen the dollar and the U.S. needs to consider devaluing the dollar. Yet, in order for the U.S. to boost demand for U.S. Treasury bonds (necessary to fund hundreds of billions of dollars in annual deficits, a $19 trillion over all deficit and over a hundred trillion dollars in unfunded liabiities) it needs to raise rates to attract capital and maintain the U.S. Treasury bond status as the safe haven.

Devaluing the dollar or not raising rates would damage that status and may lead to futher selling of U.S. Treasury Bonds.

China’s devaluation of the Yuan highlights that the Fed/U.S. no longer control the direction of global monetary policy and international trade.