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Horrid Headlines from Both Sides of the Globe

Horrid Headlines from Both Sides of the Globe

Kathy Lien, Technical Strategist

Talking Points:

  • A Huge Red Flag for China's Economy
  • Why the PBoC Is Partially to Blame
  • Bank of Canada (BoC) Scraps Hawkish Bias

Both the US dollar (USD) and Japanese yen (JPY) caught safe-haven bids this morning following the news that China wrote off three times more bad loans than expected in the first half of this year.

Investors are looking at the increase as a big red flag for Asia's largest economy, and while it reveals some of the country's deeper problems, the writeoffs are also part of the government's new strategy to clean up the books and bring default ratios in line with international standards.

Instead, we believe that the selloff in risk FX can be blamed more on the People's Bank of China (PBoC) and its decision to pass on injecting liquidity into the financial system for the second time since July 30.

The central bank generally injects liquidity twice a week, but a surge in capital flows last month has discouraged the Bank from doing so this week. As a result, the seven-day repo rate surged more than 100 basis points (bps) overnight to reach a high of 4.5% before settling at 4.05% on the day.

Tighter liquidity at a time when the world is watching the pace of Chinese growth very carefully has weighed heavily on Asian stocks, risk appetite, and high-beta currencies.

See related: China Bank News Kills the High-Beta Heyday

However, with the record profitability of some of China's largest lenders, now is the right time for them to take these writedowns because profits can still be preserved and a deep selloff in Chinese stocks can be avoided.

There is no doubt that slower growth has increased the amount of bankruptcies and failed businesses, but the Chinese government is pressuring its banks to take the writeoffs now in order to avoid a surge in non-performing loans later.

In a big-picture sense, this process will help make Chinese banks healthier in time, but in the near term, if Chinese banks set aside more funds to write off bad debt, it would reduce liquidity, an outcome that would not be kind to high-beta currencies.

A Lousy New Outlook from the Bank of Canada (BoC)

No US economic data was released today, but the Bank of Canada (BoC) dropped its bias to raise interest rates, sending the Canadian dollar (CAD) sharply lower.

The decision to leave rates unchanged at 1% was widely expected, but the grim outlook for the Canadian economy caught many investors by surprise. By dropping the prior statement that rates will need to be increased in the future and cutting GDP forecasts for 2013, 2014, and 2015, the BoC is sending a very strong message to the market that it is worried about underperformance.

The central bank sees a lower output level than previously projected, with inflation risk escalating to the downside. The improvements previously expected in both exports and investments have been delayed, and as a result, there is sizable excess capacity in the Canadian economy.

The BoC downgraded its forecast for US growth as well, which implies that the shift to a neutral bias is motivated by concerns about growth not just inside the borders, but outside as well.

Between the recent drop in oil prices and the BoC's less-hawkish bias, we believe USDCAD is poised to break 1.04.

See also: A GBP/CAD Set-up All Traders Can Agree on

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.