China's currency devaluation marks a change in foreign-exchange policy that could signal further weakness for resource prices, and by extension, Canadian stocks and the Canadian dollar.
While China's adjustment to its currency peg was relatively modest, it took global markets by surprise Tuesday, triggering a flight to safety as investors sold off stocks, commodities and emerging market assets.
"When it comes to Canada, it's yet another headwind," said Kara Lilly, a strategist at Mawer Investment Management. "Canada is so tied to commodity prices around the world. It's not just about our energy sector. It's our financial system, it's our housing market."
The stock losses were distributed liberally on Tuesday. Every major stock market index in North America, Europe and emerging markets were in the red on the day.
The Stoxx Europe 600 Index fell by 1.8 per cent, the S&P 500 index declined by 1.0 per cent and the S&P/TSX composite index gave back 0.4 per cent.
Risk aversion also weighed on commodity markets. A weaker yuan makes imported resources more expensive in China, potentially reducing global commodity demand.
Further, the currency adjustment reinforces fears for China's economy. Even if economic growth meets the 7-per-cent target, it would mark the slowest pace of Chinese expansion in 25 years.
China is the world's largest energy importer, and crude oil benchmarks dipped in reaction, compounding the effect of OPEC reporting its highest supplies last month in more than three years. West Texas Intermediate fell to $43.08 (U.S.) a barrel on Tuesday, representing the lowest settlement price since March, 2009.
The Chinese central bank cut its daily fix to the U.S. dollar by 1.9 per cent, setting off the yuan's largest single-day drop in more than 20 years.
That historical context may "overstate the degree of drama," given the yuan's long-standing stability against the greenback, CIBC World Markets chief economist Avery Shenfield said in a note. But this was a move more important for its direction than its magnitude.
"We believe today's announcement signalled a regime shift, and implies the beginning of a period of measured [yuan] depreciation," Citi analysts noted. Given that Chinese policy-makers prefer gradual, incremental change to rash reform, investors may temper their expectations for further devaluations. "But the directional signal is unambiguous," Citi said.
There is division on China's motivations for weakening its currency at this time. The central bank called it a one-time intervention intended to bring its currency closer in line with its market value.
China strives for reserve-currency status for the yuan, and the International Monetary Fund is conducting a review of the basket of currencies that make up the IMF's "special drawing rights."
"They've got a fighting chance of working their way in, and this certainly bolsters their prospects," said Eric Lascelles, chief economist for RBC Global Asset Management.
The second interpretation of the yuan adjustment is as a competitive offensive to bolster Chinese exports, making them relatively cheaper on the global market.
Fears of the escalation of a global currency war fuelled risk-off trading on Tuesday. "This was a shock to otherwise sleepy summer markets," noted Annette Beacher, TD Securities chief Asia-Pacific macro strategist.
The tremors spread throughout global asset classes. "This is good maybe for Chinese exporters, but otherwise, it's more or less negative for everyone," Ms. Lilly said.
By devaluing the yuan, the Chinese have also weakened the U.S. competitive position, while putting upward pressure on both government bond yields and the U.S. dollar, none of which is supportive of a rate hike by the U.S. Federal Reserve. But it's not yet enough to delay the Fed, Mr. Lascelles said.
"What the Fed wants to do is get that stake in the ground in terms of a first rate hike. Right now, it's going to take a fair bit to deviate from a fall 2015 tightening cycle."
But the Chinese currency is still expensive, he added. On a trade-weighted basis, the yuan is about 15-per-cent higher than it was one year ago. "They are still in very strong territory and can absolutely afford to see their currency weaken a bit more."