As noted earlier today, BofA's chief credit strategist Michael Hartnett is anything but bullish: in his own words, he remains a seller "into strength in coming weeks/months of risk assets at least until a coordinated and aggressive global policy response (e.g. Shanghai Accord) begins to reverse the deterioration in global profit expectations and credit conditions."
There is, however, one major catalyst that will take place over the weekend that could change Hartnett's mind if only for the near term: one that could unleash a "vicious bear market rally" in his words.
As Hartnett writes, "US dollar unwind may ultimately be seen as an important inflection point for US monetary conditions…signal that “automatic stabilizers” finally coming into play; means relief for “humiliated” assets in EM, commodities, resources; markets begin to discount policy response; if China FX reserves data is better than expected, we think a bear market rally is likely to be vicious."
As a reminder, here is why the world is so focused on China's FX reserves, which have seen over $1 trillion in capital outflows since the summer of 2014 when China's reserve liquidation problem began in earnest.
As a further reminder, it is the pace of Chinese capital outflows, the largest among the entire EM space, that has become the "Quantitative Tightening" counterpoint to the liquidity injections by such DM central banks as the ECB and the BOJ, and which according to many is the primary reason for the recent acute weakness across asset classes as Citi recently explained.
So what is the reported number due this coming Sunday, that could unleash a vicious rally?
It's here that things get tricky.
According to consensus estimates, China will report that its total FX reserves declined to $3.2125 trillion from $3.33 trillion: a drop of $118 billion, or modestly higher than the massive December $108 billion outflow.
In other words, a reported number below, and certainly substantially below, $118 billion for the January outflow and it would be off to the races as a massive short squeeze will grip all the commodity and materials-linked sectors.
To be sure, BofA FX strategist Claudio Piron expects a far smaller print:
We forecast China FX reserve changes and estimate a USD37.5bn fall in January – (USD29.1bn decline adjusting for a negative FX valuation effect). Note that the standard error of the forecast is large at USD24.5bn, which would give us a downside of USD84.5bn fall. We caution that this is guidance and we attempt to be as transparent as possible so investors can gauge the odds in what is a key release for the markets. Note too this is based on onshore CNY FX volumes and our estimate maybe biased down as there are no real time volumes for offshore CNH.
So yes: if the number is a paltry $37.5 billion, it would mean that suddenly China's outflows are "contained", if only for the time being, and that the PBOC may have managed to quell the relentless exodus of domestic hot money abroad (whether it's real or not is a different story).
However, just as a far smaller than expected number will be very bullish, so a far greater number will be very bearish. Which brings us to a post we wrote last week showing what may have been the main reason for the dramatic January market selloff. According to estimates by Goldman Sachs, not only have outflows not slowed down as dramatically as BofA believes, but they have in fact soared to an all time high $185 billion.
This is what Goldman said:
There has been around $USD 185bn of intervention (with the recent intervention predominantly taking place in the onshore market)" split roughly $143 billion on the domestic side and $42 billion on the offshore Yuan side.
Since then it only got worse: courtesy of Fasanara Capital we know that in the last few days, GS revised up the magnitude of the Chinese FX spot intervention to $197bn in January 2016, when adding a $12 billion valuation adjustment, lowering the total FX reserves to just $3.133 trillion!
As Fasanara accurately adds, "in case reserves drop more than consensus (as GS estimates) we could see further pressure on USDCNH and other Asian currencies, together with continued negative reaction by global markets."
In other words, Fasanara lays out the opposite scenario to that of Harnett: one where if outflows surprise to the upside, what will follow is a vicious selloff.
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So there is your bogey, one which will set the mood for risk over the next month: this weekend, China will announce its January reserve outflows which are expected to decline by about $120 billion. Should the number be far less (ostensibly closer to BofA' estimate of $37.5 billion) expect a whopper of a bear market rally coupled with a huge short squeeze. If Goldman is right, however, with its record ~$200 billion in FX intervention and implied outflows, then all bets are off.
Luckily for China, its market will be closed next week due to Chinese New Year Holiday. Which means that it will be up to US and other global stock markets to cushion the surprise until China's FX trading comes back online, and the result in this already illiquid market, could make or break many asset managers year in the span of a day.