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When China took the “surprising” (to anyone who was naive enough to think that the country’s economy isn’t in absolute free fall) step of resorting to a dramatic yuan devaluation on the heels of multiple ineffectual policy rate cuts, Beijing pitched the move as a “one-off” effort to erase a ~3% persistent dislocation in the market.

Seeing the effort for what it most certainly was – a tacit admission of underlying economic malaise and a last ditch effort to rescue the export-driven economy via an epic beggar thy neighbour along with the whole damn EM neighbourhood competitive devaluation – analysts were quick to note that the PBoC may ultimately be targeting a 10% or more depreciation in order to provide a sufficient boost to exports.

Well, official protestations to the contrary, it appears as though even some Party agencies are assuming a much weaker yuan both over the near- and medium-term. Here’s Bloomberg:

Some Chinese agencies involved in economic affairs have begun to assume in their research that the yuan will weaken to 7 to the dollar by the end of the year, said people familiar with the matter.

The research further factors in the yuan devaluation to 8 to the dollar by the end of 2016, according to the people, who asked not to be identified because the studies haven’t been made public.

Those projections — which suggest a depreciation of more than 8 percent by Dec. 31 and about 20 percent by the end of 2016 — were adopted after the currency was devalued this month and compare with analysts’ forecasts for the yuan to reach 6.5 to the dollar by the end of this year.

While the rate used in the research isn’t a government target, it suggests China may allow the yuan to fall further after a depreciation in which the currency was allowed to weaken by nearly three percent on Aug. 11 and 12. The yuan weakened for a second day in Shanghai to 6.4124.

“It wouldn’t be totally unreasonable for China to allow a weakening like this,” said Zhou Hao, an economist at Commerzbank AG (XETRA:CBKG) in Singapore, referring to the 7 level against the dollar at the end of this year. “A certain level of yuan devaluation can be accepted according to China’s international payments situation, but it may bring unforeseeable pressure on foreign debt repayments and capital outflows.”

The rate used in the research constitutes reference levels used for economic assessments and projections, according to the people. The PBOC didn’t respond to a fax seeking comment.

A dollar-yuan rate of 7 would be a more than 8 percent depreciation from Tuesday’s level. At an Aug. 13 briefing on the yuan, PBOC Deputy Governor Yi Gang dismissed the idea that China would devalue the yuan by 10 percent to boost exports, calling it “nonsense.”

Yes, “nonsense”, just like how Chinese QE “doesn’t exist” despite the fact that untold billions in stocks have been transferred from CSF to the sovereign wealth fund just so the PBoC can continue to insist that its balance sheet isn’t expanding.

In any event, a more dramatic yuan devaluation may ultimately be necessary not only to boost exports, but to alleviate the necessity of intervening constantly to arrest the yuan’s slide. As BNP’s Mole Hau put it in a note out Monday, “what appears to have happened is that, whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, [thus] the role of the market in determining the exchange rate has, if anything, been reduced in the short term.” Which explains why the FX reserve drain may well be continuing unabated causing the massive liquidity crunch that’s forced the PBoC to inject hundreds of billions of liquidity via reverse repos and ultimately forced today’s RRR cut.

Of couse as we said earlier today, “while global markets received China’s announcement with their typical ‘a central bank just came to our rescue’ exuberance, the reality is that as least today’s RRR cut will have zero impact on spurring aggregate demand, and is merely a delayed response to FX interventions that have already taken place [which means] for China to net ease, it will have to do more, much more [but] ironically, doing so, will merely accelerate the capital outflows as a result of the ongoing plunge in the CNY, which leads to the circular logic of China’s intervention … the more it intervenes in an attempt to stabilize every aspect of its economy and finance, the more it will have to intervene, until either it wins, or something snaps.”

Ultimately, that “something” may end up being the daily yuan management effort because the intervention game is getting expensive and incremental easing will only make it more so.

A free float may be the better option and if the passages excerpted above from Bloomberg are any indication, the yuan is going to be much, much lower by the end of next year one way or another. The only question is how much pain China incurs on the way there. We’ll close with the following quote from SocGen:

If the PBoC wants to stabilise currency expectations for good, there are only two ways to achieve this: complete FX flexibility or zero FX flexibility. At present, the latter is also increasingly unviable, since the capital account is much more open. Therefore, the PBoC has merely to keep selling FX reserves until it lets go.

MIDNIGHT REPORT

By Sinead Carew

NEW YORK (Reuters) - Wall Street advanced on Wednesday while European shares and commodities fell as investors balanced strong U.S. economic data and policy comments with fears about China's slowing economy.

The benchmark S&P 500 was up 0.7 percent in afternoon trading, off its earlier highs, helped by stronger-than-expected data on durable goods orders and comments that appeared to make a September interest rate hike less likely.

New York Fed President William Dudley said a rate hike next month seems less appropriate given the threat posed to the U.S. economy by recent global market turmoil.

Most U.S. Treasuries prices turned positive, erasing earlier losses, after Dudley's rate hike comments.

Europe's FTSEurofirst 300 index of major companies (FTEU3) fell 1.9 percent in a choppy trading day. China's key share indexes also ended down after attempts to move higher were slapped back by waves of selling several times, reflecting hopes for more government and central bank support.

The Shanghai Composite Index (SSEC) ended down 1.3 percent, its fifth straight day in the red as Beijing also dished out another round of trading bans.

"Everybody's just on guard and aware of the potential for greater volatility than we've seen in quite a while. We've seen investors dip their toes and buy high-quality names they like that they can get cheaper," said Brian Fenske, head of sales trading at ITG in New York. He added, "You could call me two hours from now and we could be down."

At 12:35 p.m., the Dow Jones industrial average (DJI) rose 122.43 points, or 0.78 percent, to 15,788.87, the S&P 500 (SPX) gained 13.14 points, or 0.7 percent, to 1,880.75 and the Nasdaq Composite (IXIC) added 29.44 points, or 0.65 percent, to 4,535.92.

The CBOE Market Volatility Index (VIX) was still elevated at 35.5, indicating significant uncertainty, though the "fear index" was well below Monday's 6-1/2 year peak of 53.3.

The dollar index (DXY), which measures the greenback against a basket of major currencies, pared its gains after the Dudley comments but was up 0.3 percent.

Despite China's struggles, Asia markets had some bright spots. Japan's Nikkei (N225) saw a 3.2 percent jump and Korea's KOSPI (KS11) showed its biggest jump in two years with a 2.6 percent increase.

Oil prices were hurt by a bigger-than-expected increase in U.S. gasoline stocks, compounding negative sentiment from worldwide equities that pushed fuel prices to 6-1/2-year lows.

Brent crude futures were last down 0.3 percent at $43.07 per barrel, while U.S. crude was down 0.9 percent at $38.97.

Copper, often considered a proxy for Chinese and global economic activity, was down 3.1 percent tumble while prices of gold , traditionally a safe-haven asset, were off 1.4 percent.

© Reuters. Dudley, president and chief executive officer of the Federal Reserve Bank of New York, attends the Economic Club of New York Leadership Excellence Award in New York

By Jonathan Spicer

NEW YORK (Reuters) - An interest rate hike next month seems less appropriate given the threat posed to the U.S. economy by recent global market turmoil, an influential Federal Reserve official said on Wednesday.

In the clearest indication yet that fears of a Chinese economic slowdown could influence U.S. monetary policy, New York Fed President William Dudley said the prospect of a September rate hike "seems less compelling" than it was only weeks ago.

Dudley, a dovish policymaker and close ally of Fed Chair Janet Yellen, however left the door open to raising rates for the first time in nearly a decade when the U.S. central bank holds a policy meeting Sept. 16-17.

The global selloff, brought on by weak Chinese economic data, threatens to crimp global growth and create financial conditions unsuitable for a initial policy tightening in the United States, he said.

"At this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago," Dudley told reporters at the New York Fed, of the policy-making Federal Open Market Committee.

But an initial rate hike "could become more compelling by the time of the meeting as we get additional information on how the U.S. economy is performing and (on) international financial market developments, all of which are important to shaping the U.S. economic outlook," he said.

Market turmoil in recent days, including steep stock sell-offs in Asia, Europe and the United States, has called into question the Fed's plans to raise rates possibly as soon as next month. Investors and economists have pushed out their expectations for the Fed to move in December or next year, citing the rising dollar and falling oil prices.

The comments, which lifted the dollar and U.S. Treasury bond prices, come a day before many of the world's top central bankers gather at an annual conference in Jackson Hole, Wyoming, to which investors will look for clues on how the turmoil could rattle monetary policy plans.

Dudley's comments were unprompted and made at a briefing on the regional economy, suggesting they were a deliberate message from the broader Federal Reserve.

He said he wanted to see more U.S. economic data, and also how markets behave in coming weeks, before making a final judgment on the timing of policy tightening.

"International developments have increased the downside risks to U.S. economic growth somewhat," he said, with China's slowdown and falling commodity prices straining emerging markets and raising the possibility of slower global growth and less demand for U.S. goods and services.

The volatility has tightened financial conditions and widened credit spreads, he said, adding inflation remains "well below" the Fed's 2 percent target due to falling oil prices and the strength of the dollar, "which we expect to be transitory."

"It's important not to overreact to short-term market developments because it's unclear whether this will just be a temporary adjustment or something more persistent that will have implications for U.S. growth and the inflation outlook," Dudley said.

Only a "large and prolonged" stock market drop could potentially weigh on Americans' willingness to spend, he added.

Asked about the possibility of another round of stimulative bond-buying, Dudley said the U.S. central bank is "a long way from" that. He added that the market turmoil "is not a U.S. problem" and was sparked by "developments abroad."

While the U.S. labor market has been strong, prompting many Fed officials to consider hiking rates in September, inflation has been weak with little sign of rebounding.

JPMorgan's chief U.S. economist, Michael Feroli, wrote that the Fed's message was that, "while a September liftoff is not ruled out, the onus is on the data to remain strong and for markets to calm in order for that to happen." 

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