Has China just issued a warning to Janet Yellen?

While everyone was worrying about the sell-off in oil and high-yield bonds last week, China made a little adjustment.

The country changed the way that its currency, the yuan, moved in August, which rather unnerved markets. So far however, the yuan has yet to crash against the dollar – the authorities have made sure of that – which was the biggest fear.

But on Friday, we saw another shift. The yuan is now set to track a basket of currencies. That’s significant because it shifts focus from the US dollar.

So is this a prelude to a devastating deflationary slide for the yuan? Or something less dramatic?

That might depend…

China’s brand new shiny currency basket

You can see why China might not want to have its currency effectively pegged to the US dollar.

The Federal Reserve is set to raise US interest rates tomorrow. It’s not a done deal, but the US dollar has strengthened sharply ahead of the move, and depending on what the Fed plans for future rate rises, it could conceivably go even further.

That’s not a currency that China wants to track. China doesn’t need tighter monetary policy right now (which is what a stronger currency gives you). If anything, it wants weaker monetary policy to boost its fragile economy.

So it’s de-emphasising the role of the dollar in setting the yuan’s value, and upgrading the role of other, weaker currencies. As analysts from Société Générale told Bloomberg, the Chinese central bank “is clearly preparing the market to interpret a weaker yuan versus the dollar not being devaluation”.

So far this year, the yuan is down around 4% against the dollar. But it’s up against “12 of 16 major currencies tracked by Bloomberg”.

The big fear, of course, is that the yuan will plunge against the dollar. That would represent a major escalation in the ‘currency wars’, and the danger is that China could export deflation across the globe.

As Capital Economics’ Julian Jessop puts it, if the yuan “does fall a lot further, the global fall-out will almost certainly be negative… it might set off a downward spiral as other countries seek to maintain competitiveness. Additional broad-based dollar strength would then increase nervousness in emerging markets and add to the downward pressure on commodity prices.”

Jessop reckons this is an outside chance. Instead, he thinks China will keep the yuan relatively stable, with any further devaluation against the dollar being relatively small – 5% over the next year.

But it’s interesting timing, don’t you think? You could argue that it’s because China doesn’t want to be swept higher with a strong dollar. But you could also argue that it’s something of a warning shot to US Federal Reserve chief Janet Yellen.

The last thing Yellen wants is a dose of deflation being dumped on the world right now. Her goal is inflation, after all. She has to be keenly aware of how much of a threat the strong US dollar poses to emerging markets – and if she wasn’t, China’s decision to slacken its ties to the dollar is a very clear signal.

It’s another pressure that will make tomorrow’s decision even more nerve-racking.

Playing pass the parcel with a lump of coal

Then of course there’s the fun in the high-yield bond market.

I’m noticing one interesting reaction to all the havoc. A lot of the Twitterati and other pundits are arguing that the level of attention the Third Avenue blow-up is drawing means that this can’t be a big problem.

An article by popular gossip website Gawker highlighting junk bonds as something to worry about was seized on by many as a ‘buying signal’.

Matt Levine on Bloomberg noted that this “is the most anticipated crisis since, you know, tech bubbles”.

This is a comforting idea. There’s this common misconception that no one sees bear markets coming. So if one looks obvious, it can’t actually be a popping bubble.

But looking back at the history of bubbles, this just isn’t true. (And given the example Levine chooses, it’s clear that he knows this.)

For a start, while bear markets unfold more quickly than bull markets, they still take a long time to unravel. In the dotcom crash, the Nasdaq didn’t go from 5,000 to 1,100 overnight. It took time. And all the way down, there were people arguing that the selling would stop any day now.

And contrary, perhaps, to popular belief, plenty of people saw it coming. Jeremy Grantham of GMO tells a great story that I’ve noted here before, about taking a poll of his peers in 1998 and 1999. Grantham had sat out the tech bubble, taking an “Emperor’s New Clothes” stance to the whole thing – sacrificing both performance and clients in the process – and wanted to know what other managers’ feelings were on things.

Turned out that the vast majority of them felt that the market was overvalued, and that a major bear market was coming – at some point. But they all felt that they had to hold stocks. Otherwise they would underperform their rivals and the market, and get fired.

It was the same in 2007/08. The mood among the City people we talked to here at MoneyWeek – even the ones you’d generally view as mainstream, non-contrarian thinkers – could best be described as one of ‘skating on thin ice’. But you can’t just walk off and hang up your skates, because it’s your job to be invested. So you make up half-hearted reasons for sticking with a market, even when it looks set to splinter.

So like it or not, the fact that a bubble ‘looks’ obvious, doesn’t mean that it isn’t a bubble. Ignore what people say – it’s what they do that matters. If an asset is priced at bubble levels, it’s because someone bought it at that price, regardless of how sceptical they might have been about its prospects.

I’ve lost count of the number of times during the post-crash era that I’ve heard a resigned “Well, what else are you going to do with your money?” given as justification for buying one asset class or other.

And that’s what matters with bubbles. It might start with a good story. It might start with a cheap asset. It might start with a superb investment.

But by the endgame, it’s all about pass the parcel. As long as the music keeps playing, you keep passing the parcel along, paying a bit more each time it goes by.

But when the music stops, you have to open it, and you find that it’s not a diamond anymore – it’s just a lump of coal. And suddenly your circle of willing buyers is heading for the door.

Central banks have been hugely successful at forcing investors to take low-conviction bets, and to reach for yield, for want of anything else to do. That success may be about to come back and bite them.

Or maybe – just maybe – come Wednesday night, Yellen will be just too scared to turn the music off.