One of the widespread consensuses in financial markets is that the US Federal Reserve is planning a rate hike, most likely in September.
China’s devaluation made that just a little less certain, meaning the era of cheap money could last bit longer.
Jim Reid, a key Deutsche Bank strategist, said: “A full blown China devaluation would surely stop the Fed dead in their tracks and the even threat of it may slow them down.”
“The probability of a September US hike went down from 48% before the announcement (and 54% late Monday) to 40% currently,” said Reid.
There are concerns, voiced strongly by uber-bear Albert Edwards at Societe Generale, that currency devaluation in China and the rest of Asia will lead to deflationary pressures in the US through cheaper imports. Raising rates would strengthen the dollar and only make that worse.
Here’s a good chart from DBS Group Research that shows how the recent yuan devaluation could lead the currency back to low levels against the dollar not seen for decades:
Deutsche Bank argues that a currency war, where countries try to keep their currencies weak against those of trading partners, might cause some volatility.
But at the same time it will help maintain the massive bubble of cheap money and liquidity currently propping up the world’s markets.
Almost every asset — from bonds to stocks to venture capital investments in profit-free tech companies — depends on the cheap money flowing to keep growing.
For banks, the liquidity is like a heavy blanket. It helps them avoid losses on poor-quality assets but subdues their profit margins on lending activity.
At some point, this has to come to an end and interest rates will go back up.
So one has to balance the risk of a destabilising currency war with the extra global liquidity it would bring.
Net net we still think the global financial system is incredibly fragile and essentially being artificially propped up by mass liquidity.
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