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Is Trump's anti-China rhetoric going to trigger another currency war with China? If so, China may jump out ahead and devalue the Chinese yuan.

In that case, the Dow Jones Industrial Average could plunge to 17,824, and the S&P 500 could plunge to 2,024 in a matter of weeks, wiping out trillions of dollars of investor wealth.

This is not guesswork. Plunges of over 10% in U.S. stock indices happened twice in the past year-and-a-half. The first time was in August 2015. The second was January-February 2016. Both times it was because of a combination of a stronger dollar and weaker yuan. It could happen again. And you need to understand the dynamics both to avoid losses and reap big gains by positioning ahead of the meltdown.

Here's a quick synopsis:

• China is struggling under the weight of too much debt, poor demographics, and competition from lower priced suppliers in Vietnam, Indonesia, and the Philippines.

• China needs economic relief. Fiscal stimulus just means more non-sustainable debt. China has too much of that already. The easiest way to give the Chinese economy a boost is to cheapen its currency, the yuan (CNY), to make its exports more competitive.

• When China cheapens CNY, they encourage capital flight. We're seeing that now. Over $700 billion fled China last year alone. The wealthy and well connected try to get their money out of China as quickly as possible before the next devaluation. This causes the dumping of Chinese stocks, which could then infects U.S. stock markets and causes a global liquidity crisis. The last two times China devalued, U.S. stocks fell over 10%.

From early March to mid-May 2016, the yuan was stable against the dollar, and the dollar got weaker against the yen and euro. U.S. stocks staged a major rally from around 16,000 to almost 18,000 on the Dow Jones Industrial Index. It seemed that all was right with the world.

Unfortunately, the Fed could not leave well enough alone. Instead of celebrating this truce in the currency wars, the Fed began talking about interest rate hikes possibly in June or July.

The hawkish tone was expressed by several regional reserve bank presidents, notably James Bullard, Loretta Mester, and Esther George. The dollar rallied almost 4% in a few weeks. That's a huge move in currencies where changes are usually registered as small fractions of 1%.

At that point, China felt double-crossed by the U.S. and began a new devaluation against the U.S. dollar. This new devaluation effort came on top of the first devaluation ?shock? of August 10, 2015 where the yuan was devalued 3% overnight, and a second "stealth" devaluation from December 2015 to January 2016. It was a stealth devaluation because China moved in small increments every day instead of one huge devaluation in a single day.

The shock devaluation and the stealth devaluation both took place while the dollar was getting stronger in anticipation of U.S. rate hikes. That anticipation was fueled by the Fed, which starting talking about rate hikes. The result was the dollar strengthened and the China devaluation began.

What do all of the currency wars moves have to do with U.S. stocks?

The answer is the USD/CNY cross-rate may be a more powerful determinant of stock prices than traditional barometers such as earnings, stock multiples or economic growth.

By last July, the Dow Jones Industrial Index (DJIA) hit a then all-time high of 18,533.05 and the S&P 500 also reached an all-time high of 2,166.89. But, those indices were close to those levels on two previous occasions, August 10, 2015 and December 16, 2015.

Both times China began to devalue and both times U.S. stock markets sank like a stone.

The DJIA dropped 11% (Aug. 10 to Aug. 25, 2015), and 12% (Dec. 16, 2015 to Feb. 11, 2016). It's now at 19,804. If history repeats and China devalues again, DJIA could drop to 17,824 or lower, and the S&P could drop to 2,024 or lower.

The process of a new crash had already started early last June, but the crash was ?saved by Brexit.? The Brexit vote caused an immediate collapse in sterling and the euro and led to a ?risk off? flight to quality in dollars, gold and U.S. stocks. The Brexit bounce is long over but the post-election Trump reflation trade took stocks to nosebleed levels. The Dow has been flirting with the mythical 20,000 mark.

The question is will history repeat itself, will China devalue again… or will this time be different?

At Currency Wars Alert, we use our proprietary IMPACT method to spot the next moves in major currency pairs. IMPACT is a method I learned in my work for the U.S. intelligence community including the CIA, and the Director of National Intelligence.

It's based on what the intelligence community calls ?indications and warnings.? Even in the absence of perfect information, you can tell where you're going by unique signposts along the way.

What are the indications and warnings we see on CNY/USD?

Currency pairs don't move in a vacuum. They move in response to interest rate policy including forward guidance about policy. To a great extent, interest rates and exchange rates are reciprocals. If interest rates are higher, or expected to go higher, the currency will strengthen as capital flows in to take advantage of higher yields.

If interest rates are lower, or expected to go lower, the currency will weaken as capital flows out in search of higher yields elsewhere. The knowledge that currency rates reflect trade deficits and surpluses is mostly obsolete. Capital flows dominate trade flows in the determination of exchange rates.

When China devalued the yuan in August 2015, capital outflows surged. Once the yuan stabilized against the dollar in early 2016, the capital outflows were greatly reduced. That's since changed. Now, early in 2017, capital outflows from China have reached unsustainable levels. If it keeps selling dollars to prop up the yuan, China will burn through all its dollar reserves by the end of the year at the current rate.

I'm keeping a close eye on these outflows. They're one of the main indications and warnings I'm watching to determine the timing of the next Chinese devaluation.

In the short-run, U.S. stocks could be headed for a fall since the Trump reflation trade is running out of steam and renewed tough talk by some Fed officials of additional hikes suggests a stronger dollar. Right now it looks highly likely that the Fed is going to raise in March after raising in December.

The Fed is concerned that U.S. stocks are in bubble territory. They suggest that the easier financial conditions caused by higher stock prices make this a good time to raise interest rates. The rate hike talk then makes the dollar stronger and puts pressure on the yuan. An unstable yuan triggers capital flight, which causes a spillover liquidity crunch, which in turn could lead to a correction in U.S. stocks.

Once the correction takes place, the Fed can try to rescue the stock market again with more dovish signals. That would weaken the dollar and stabilize the yuan. But the risks are that the Fed has not learned from its past mistakes and late March-to-April 2017 could be a replay of August 2015 and January 2016.

And after all these years of market intervention, the Fed may well be out of powder to handle another crisis.

Fasten your seatbelts.

Regards,

Jim Rickards
for The Daily Reckoning

The post Is China About to Drop a Bombshell? appeared first on Daily Reckoning.