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Impact of China Slowdown and Capital Flows on FX Markets.

We have seen USD strength return following speeches from the FOMC members on Monday stating a likely rate rise by the end of 2015. However, the Caixin China Manufacturing PMI Flash for September has come in at 47.0, worse than an expected 47.5. What’s even worse is that the new orders sub-index dropped 0.6 percentage points to 46.0, while new export orders sub-index fell 0.8 percentage points to 45.8. This data shows a further worsening of the economic outlook for China and given US Fed concerns over developments abroad (especially in China), financial markets are likely to price in the first rate hike in Q1 2016.  

In the short-term the worsening economic outlook for China is likely to be negative news for the Commodity Bloc currencies such as AUD, CAD, NOK, and NZD, which already remain vulnerable to further rate cuts from their respective central banks.  Also the current market volatility has led to a reduced investor appetite for risky assets and a reversal in the carry trade. As a result, safe haven currencies like EUR, GBP, CHF and JPY may find support over the short-term.

Over the longer-term, policy divergence is likely to drive the FX markets. With seven out of nine other G10 countries introducing fresh easing measures in 2015 and the Riksbank, the Norges Bank and possibly the BoC likely to deliver more rate cuts in coming weeks and the ECB continuing its asset purchase program (may even be expanding it), we forecast a gradual weakening in NOK, SEK, CAD and EUR vs. the Dollar. 

The US capital flows also bode well for the USD over the long-term: the latest TIC data shows that despite a sharp drop in China's FX reserves and persistent outflows from foreign central banks, there has been a net positive inflow in US treasuries, this is due to foreign private buying of US treasuries.  This is consistent with a view that capital flows were driven out of the U.S. at the start of QE and capital is now flowing back in to the U.S. as the Fed looks set to raise rates soon.