January nineteenth, two thousand twenty-five (250113-250119)
One, Inauguration day, tariffs, and exchange rates
The current onshore yuan-dollar spot exchange rate It has already approached the daily 2% upper limit of the midpoint trading band If the aim is to let the yuan depreciate further, the midpoint needs to be raised to leave room for the spot rate to fall further.
The market broadly expects that, if Trump imposes tariffs on China, this could become the trigger for the PBOC to allow the yuan to depreciate further. But actually If the initial tariffs are relatively moderate (for example, only 10%), the PBOC may make only small adjustments to the yuan’s central parity rate over the next few weeks or even 1-2 months, keeping it below 7.2.
In fact, Since 2023 8, China has reclaimed more than 1000 hundred million U.S. dollars in foreign exchange reserves This makes the cost of limiting yuan depreciation manageable and feasible in the short term.
Chart: By buying back dollars while the yuan appreciated, China’s net foreign assets recovered 1700 hundred million U.S. dollars since 23 8
In addition, the real effective exchange rate of the yuan, REER, is currently at its lowest level since 2014—22’s peak is lower by 14%, enough to offset moderate tariffs on Chinese exports to some extent. This is mainly because China has little inflation while inflation is higher elsewhere, which will keep Chinese goods competitive.
Chart: REER has room
According to GS’s calculations, if the United States imposes an additional 10% tariff on Chinese goods, the yuan REER would need to depreciate by 2% to offset the impact on exports, whereas The current REER is clearly sufficient to absorb this impact.
Chart: GS’s calculations
The current aggressive efforts to smooth the foreign-exchange market are similar to those in the third quarter of 23, when the PBOC used forceful intervention to keep the offshore yuan against the U.S. dollar near 7.35 for 2-3 months, until a weaker dollar pushed USDCNH lower.
Although USDCNH may eventually move higher from here, in the short term the PBOC will most likely continue to keep the onshore yuan’s central parity rate below 7.2, thereby limiting the upside in USDCNH.The market is currently heavily positioned above USDCNH, which may trigger some position liquidations, causing USDCNH to undergo a shallow correction and fall back toward 7.25.
Two, The rate-cut cycle and interest-rate differentials
To avoid putting more pressure on the yuan as the U.S.-China interest-rate differential widens, The PBOC may delay its rate-cut plans. The recent selloff in front-end rates has already partly reflected this expectation, especially as the PBOC also wants to curb financial risks arising from the rapid rally in Chinese government bonds.
Against the backdrop of the ten-year Chinese government bond yield falling by 90 basis points last year, The PBOC has stopped buying government bonds this month, instead allowing fiscal policy to play a greater role in driving growth.
Three, India is looking shaky
NIFTY is experiencing its steepest decline since 22, with the Indian market down 12% since the end of 9, while the Indian rupee has depreciated by 3.5%.Foreign investors have been persistent net sellers since the start of the year, with sales totaling 45 hundred million U.S. dollars, Domestic Indian institutions have remained persistent net buyers, with purchases totaling 54 hundred million U.S. dollars. The bank index with relatively high foreign investor ownership (Bank NIFTY) has continued to underperform, lagging the NIFTY index by 300 basis points.
Buying by domestic Indian investors alone is no longer enough to support the market. Domestic institutions have made net purchases of more than 300 hundred million U.S. dollars during this downturn, Meanwhile, several early industry trends can be observed so far this earnings season:
1) Axis Bank, the first major financial stock to report earnings, faces sluggish growth and deteriorating retail asset quality, with EPS being continuously revised downward; at present The financial sector is more of a trap than a value opportunity.
2) The results and management commentary from technology companies (such as INFY, TCS, and LTIM) point to an improving environment for discretionary spending (despite weaker seasonality, all these companies reported accelerating revenue growth). But LTI’s comments on the impact of Gen AI on Mindtree’s revenue now support the structural bearish view on technology, limiting further upside in valuation multiples.
Per LTIM, growth in this quarter had a positive impact of seasonal pass-through revenue in manufacturing, but was offset by furloughs and AI-driven productivity pass through to one of LTIM's large Hi-tech clients. LTIM mentioned that 3Q saw a 2-month impact of the productivity pass-through, they expect at least one more quarter of impact, before it starts to stabilise.
Hi-Tech declined 6% qoq, driven by AI productivity pass-through to a large client and LTIM expects the full impact of this in 4Q. In retail, LTIM is seeing stable demand environment.
The origins of the problem can be traced back to 2 of last year when Rahul Jain warned that Unsecured loan books at local Indian banks were beginning to come under pressure.
After that, the Reserve Bank of India tightened its lending standards for retail loans. Today, The pressure from tighter lending has begun spreading across several sectors, and delinquencies in commercial vehicles and small and medium-sized enterprises are starting to rise.
In addition to pressure on consumers, India’s debt-to-GDP ratio has risen to around 85%, which will force the government to cut fiscal spending, The market is also closely watching India’s budget, due to be released on 2 1 If the budget is poor, If government spending remains subdued over the coming year, while tight domestic liquidity in India pushes up short-term interest rates and further squeezes growth, there may be further downgrades in the coming months.
Four, The Federal Reserve’s rate path
After the 12 employment report, The prevailing view among Wall Street firms is one rate cut each in 25 6 and 12, with the third cut pushed back to 25 6; this The previous expectation was one cut each in 3, 6, and 9 of 25, for three rate cuts in total.
For market pricing, see Notes 250115 Extreme Market Pricing and Inauguration Day Actions
Bond markets currently price in only one Fed rate cut in 2025, of about 28 basis points, while some investors in the U.S. equity market are currently pricing in 0 cuts, that is, no rate cuts at all; in addition, the market also expects interest rates to rise gradually in 2026 until 2026 12.
Chart: Market consensus pricing
Chart: Market implied probability of rate hike (next 12 m)
Why is the market pricing in such a high path for the federal funds rate, with only one rate cut shown over the next few years?
The chart below uses options to show the market’s probability distribution across different ranges for the federal funds rate two years from now, The market has sharply reduced the probability weight on federal funds rates at levels that could correspond to a recession scenario, reallocating that weight to scenarios where rates remain high rather than to the middle range that FOMC might consider neutral and would want to keep rates at in a soft landing:
In other words, the bond market has already judged the likelihood of a recession to be lower. This is really a case of having learned from experience; see Notes 240106 Divergent Market Bets: What We Learned.
“Over the past two years, equity and credit investors have captured significant market alpha on the strength of their conviction in a soft landing,rate investors, however, were shaken out by the market’s sharp volatility, mainly because they relied too heavily on recession-risk assumptions and favored duration-heavy asset allocations..”
Don't fool me twice!
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