After years of speculation, China has finally dropped its peg to US dollar. The pegged value of the RMB or Yuan has been adjusted to 8.11 from 8.31. This humble revaluation of 2.5% will for the most part do little to ease the United States’ trade deficit. It does however have significant political and market implications. Most US Senators feel that the revaluation move was too small and that China needs to allow the currency to increase in value, especially since 2.5% pales in comparison to the RMB’s predicted undervaluation of 30-40%.
China is keeping its 0.3% percent daily trading band against the dollar, which means that even with this move there will not be a lot of volatility in the currency pair. China has many reasons to want to revalue their currency. The revaluation also makes imports cheaper for China. This comes at a critical time when commodity prices are rising. The revaluation immediately makes prices of commodities such as oil 2.5% cheaper for the Chinese.
China’s move has many consequences for all of the financial markets. The most significant of which will probably be in US treasuries. China is the world’s second largest holder of US treasuries. China’s revaluation and move to a basket float significantly reduces their need for US treasuries and could potentially take away a big buyer from the market. If this is the case, it will cause bond prices to decrease and long-term yields to rally, which could offset some of the additional pressure on the Federal Reserve to continue raising rates. If China even begins to dump US treasuries, we could see the “yield curve conundrum” begin to fix itself. "Yield curve conundrum" refers to how Federal Reserve Board Chairman Alan Greenspan described the strange result that, despite six successive 25-basis-point increases in the federal-funds rate since June 2004, longer-term interest rates actually declined during the same period.
The reduced demand for US treasuries and the possibility of increased demand for other currencies such as Euros and Japanese Yen could be very detrimental for the US dollar. Right now, the dollar is holding somewhat steady against the Euro due to the fact that China has yet to announce the currencies within the basket they plan to use to base the float on. Once they confirm that the Euro will be included in the basket, the single currency could skyrocket. The one major currency pair that will be impacted the most by the revaluation announcement would be the Dollar against the Japanese Yen (USD/JPY) and indeed the pair slid 200 pips or points following China’s announcement. Malaysia has also stopped pegging the Ringgit to the dollar and has adopted a managed float. The revaluation of the RMB makes Japanese goods more competitive on a relative basis against Chinese goods.
The stock market should have a mixed reaction. Shares of companies such as Wal-Mart and Target have and will probably continue to sell-off because the revaluation causes their cost of...