Trade

China warns hot money – Japan reverses energy policy – A monkey wrench for the yen one-way bet?


Chinese leaders’ know well the danger of a hard landing via the transmission of cascading defaults on rising debt across companies in key industries. And they also understand the solution to this problem requires a delicate balancing act—they must deal with hot money and the Fed taper all the while their economy’s growth is decelerating in the face of reform.

China recently adjusted the unknown basket against to which their currency “floats” in order to show hot money players that one-way bets can be risky:

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In addition to the hot money problem, a weakening of the yuan also helps another problem nagging China—the massive depreciation of the Japanese yen adding unwanted competitive pressure on Chinese exporters:

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But the other side of this balancing act is that “taper thing.”  It is still unknown just how much liquidity might drain from China on Fed tapering and corresponding slowdown in growth.  Officially, China seems confident, but guarded, inward investment flows will remain strong in 2014:


BEIJING, Feb 25 (Reuters) - China is likely to see relatively big net capital inflows this year, though the U.S. Federal Reserve's tapering of its stimulus programme could help ease some pressures, the country's foreign exchange regulator said on Tuesday.

“…Especially when the QE tapering gradually takes effect, the pace of increases in the funds outstanding for foreign exchange may ease or even drop," SAFE said on its annual capital flow oversight report, referring to the Fed's quantitative easing programme involving massive bond purchases.”


The second paragraph above seems to hint the yuan may be on a weakening path and the recent weakening is more than a one-off to scare away some hot money.

What might be some trade ideas to glean from this information, adding one more tid bit--the Japanese government has reversed themselves on the nuclear policy.

  1. Long USD/CNY [weakening yuan]
  2. Commodities basket continues under pressure
  3. Oil seems especially exposed given the fact, i.e. future expected oil demand from Japan will require a re-write now on their move back to nuclear. 
  4. A shift back to nuclear will likely help the current account deficit in Japan, which means fewer yen sent out into the world.  This may throw a monkey wrench into the yen weakens “forever” theory. 
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Fed up. In Italy ...

The Federal Reserve is up to bat again today. And it seems the bets on tapering are rising with each passing moment.

Let's just say I'd be surprised if they announce tapering today. I have several reasons why, but let's just say the state of things in Italy is on the Fed's radar screen.

As it pertains to tapering expecatations, we've provided thorough details and analysis in recent issues of Global Investor (for paid members only.) But let me summarize a few pieces with broad strokes:

 

 

  • Inflation is not pressuring the Fed to change policy
  • Potential adverse global market reaction to a perceived change in rates is pressuring the Fed to sit tight
  • Further, tapering could counteract the influence of Japan's Abenomics which accomodates a renewed yen-carry trade
  • The adoption of the Volcker Rule creates new uncertainty in the US financial system
  • The fragility of the European financial system has become heavily dependent on Fed activity

 

 

I think most of those items are self-explanatory. But let me update you on the latter ...

If you don't regularly read Ambrose Evans Pritchard in The Telegraph, you should. He's very thoughtful and very critical. And his focus tends to be on the Eurozone. (Note: As good as Pritchard is, try not to let his analysis dictate your trade timing. It doesn't work even when it sometimes feels like it must!)

Anyway, he had a piece published yesterday: Italy’s president fears violent insurrection in 2014 but offers no remedy

And here is the crux of his piece, questioning why Italy is in the crummy predicament to which its President admits:

Now why might that be? Might it not have something to do with the central overriding fact that Italy has a currency overvalued by 20pc or more within EMU: that it is trapped in a 1930s fixed-exchange system run a 1930s central bank that is standing idly by (for political reasons) as M3 growth stalls, credit contracts, and deflation looms?

And later he goes on to say:

To those who keep insisting that Italy should tighten its belt and claw back competitiveness by cutting wages, I would contend that this is mathematically impossible in a climate of EMU-wide deflation or near deflation.

The reason should be obvious to everybody by now. You cannot allow the nominal debt stock to rise on a shrinking nominal base. Such a policy causes the debt trajectory to spiral upwards. Italy’s debt has already jumped from 119pc to 133pc of GDP in the last three years in large part because of the fiscal austerity policies.

Yeah, it should be obvious. But that doesn't mean it won't continue to be ignored ... by Germany.

One may be inclined to think the Eurozone is on the mend just like the US, just behind the curve a little bit. We hear all kinds of things about how valuations in Europe are attractive. But I'd argue that assumes a lot for the Eurozone's growth future. I think "attractive" valuations are also relative, i.e. how European markets stack up to US markets. (Doug Kass recently stated he thinks US markets are 8 to 10 percent OVERvalued.)

The biggest threat to Europe-on-the-mend is political and social discontent.

Germany this week launches its grand coalition, a deal between parties on which direction to take German policy. And it's not been met with kind words. From The Telegraph:

“The agreement does not contain anything that would solve the European debt crisis, re-ignite growth in the euro periphery, or dampen the disastrous impact of austerity,” said Sebastian Dullien from the European Council on Foreign Relations in Berlin.

Prof Dullien said it had blocked a viable EU banking union and left in place the “toxic vicious cycle” between weak banks and weak sovereign states, each at risk of pulling the other down.

Geez. What more is there to say?

Alright, since you praise my every utterance, I'll explain what this means in my own words:

Germany will not be making any changes that meaningfully impact the Eurozone dilemma in a positive way.

And guess who isn't going to like that? Perhaps the rest of the eurozone, maybe? From an older Pritchard article:

... the new plan of Romano Prodi, Italy’s former premier and “Mr Euro”. He is now calling for Italy, Spain, and France to band together rather than deluding themselves that they can go it alone, and to “bang their fists on the table”.

Nobel economist Joe Stiglitz echoes the theme at Project Syndicate. “If Germany and others are not willing to do what it takes – if there is not enough solidarity to make the politics work – then the euro may have to be abandoned for the sake of salvaging the European project,” he said.

Frankly, nothing is going to get done in Europe anytime soon. 

The best they can hope for is a perpetually effective perceptions management campaign led by the European Central Bank's own Mario Draghi. His strategy (similar to most policymakers of the last few years) is to air some of the eurozone's dirty laundry (namely, vague concerns for Eurozone growth) so markets feel like they're in the know.

But regardless of the "disclosures", if the markets get blind-sided by what's really preventing progress in the eurozone economy, they'll get spooked quickly.

And one more blurb from a different Prtichard piece:

“Every 10pc rise in the euro costs France 150,000 jobs,"said Montebourg. "Britain, the US, Japan, all have a strategy of monetary stimulus, but in the EU we have nothing but hard money and hard budgets. The currency doesn’t belong to bankers, and it doesn’t belong to Germany, it belongs to all members of the eurozone, and we have something to say about this,”

Is that a threat to invoke Article 219 of the Lisbon Treaty giving EMU ministers the final say over the exchange rate, a power that lets them dictate monetary policy by the back-door, provided the Commission plays ball?

A Deutsche Bank study said the euro “pain threshold” for Germany is $1.79 to the dollar. It is $1.24 for France, and $1.17 for Italy, a staggering difference. The euro ended last week at $1.35. This means Germany is sitting pretty, and it is Berlin that dominates the policy machinery.

Yes, indeed -- the US has a strategy of monetary stimulus. And the arbiter of that stimulus is very mindful of the situation in Europe and its potential contagion effects if Fed tapering sparks a rethink in markets.

Tapering rhetoric shocked markets when first broached in May. At most the Fed will test out the rhetoric again today so that they may see how markets react. But ultimately they are stuck because they've generated a global "wealth effect" dependent upon monetary stimulus.

-JR Crooks

Comment

Setting up for a US growth disappointment

It seems the US trade deficit data released yesterday went largely unnoticed. And that's usually how it goes each month, probably because there tends not to be much, if any, knee-jerk market reaction to that report.

But considering how most markets have been moving this week (up), it got me thinking about how the trade numbers might influence markets over the next few weeks ...

To recap: the US trade deficit widened sharply in August. That followed the previous month's narrowing to a level not seen since October 2009.

I was particularly wondering how this might impact the US dollar. There is not a tight correlation between the US trade balance and the US dollar, especially over the shorter-term. But the widening trade deficit is a nod to the typical dynamic -- trade imbalances -- that's characterized global growth over the last decade.

Manufacturing PMIs in US, Europe and China are all higher in the most recent month, poking above the 50-level that delineates expansion and contraction.

Despite the recent scare over emerging markets, many are quick to notice a general stabilization in global growth expectations.The US economy has been the least of the concern for investors. But if the world is seen to be stepping back into what's been a typical growth pattern, then maybe Asia (namely China) gets cut some slack. 

In an environment where things seem to be "back to normal," then maybe we see capital exit the US in search of return. Maybe the US dollar loses any safe-haven appeal and is potentially looked at as a funding currency. And maybe most markets around the world feel a reprieve from recent selling pressure.

Obviously this is all speculation on my part. And it's all speculation that I imagine would run its course in a relatively short period of time, say three to six weeks.

So I may be stretching it to think the trade deficit could have such an influence on markets in that amount of time.

But one reason (among many) I tend to think such a "back to normal" growth mentality won't last too long: the recent US GDP beat was driven largely by a surge in exports.

As mentioned, the latest trade deficit number showed the surge in US exports reversed last month. In other words: come the end of September or early October, everyone may be rethinking their expectations for the US economy. And if they start rethinking the US, chances are they'll start rethinking global growth as well.

This chart is from Part 5 of a five-part series The Wall Street Journal put together on "China's Rising Risks." Click the image to access the article.

September is well known for being the worst month for US equity market performance. That may be reason enough to expect the opposite in the early going. After all, the catalysts for market weakness -- mainly concern for emerging markets and rising interest rates -- are probably overdone in the near-term.

I expect a reprieve from general selling pressure in global equity markets and other risk assets over the next few weeks. In that environment, the US dollar probably will be pressured lower. Once the US dollar is again looked at as a dog, it should be about time for it to head higher as many have been quick to forecast in recent months.

-JR Crooks

 

Comment

Currency Warriors WRONG; Now Emerging Markets are on the verge of crisis

Click here to read in PDF format ...

The emerging (developing) market [EM] currencies are getting clobbered.  It seems the idea of EM growth as far as the eye can see, as once heralded by the BRIC lovers, is fading fast.

Source: Financial Times 

The realization that EMs lack enough internal demand and depth of capital markets is coming home to roost.  They have not been able to sever their dependence (remember how we have been sold on the bill of goods called “decoupling” by many EM sponsors) on those dead old industrialized economy consumers.  And the demand from their new leader -- China, where much of its growth depends on those dead old industrialized economies -- is adding to EM woes ...

Interesting that not long ago all of those armchair currency warrior analysts were so worried about all that money pushing those EM currencies to the moon.  Now, EMs are doing all they can to prop up the value of their currencies.  Shouldn’t that be considered war against the United States dollar and other industrialized world currencies now?  Oh where have you gone currency warriors (sung to the tune of “Mrs. Robinson”) ...

I wonder if Jim Rickards’ book, Currency Wars, has hit the give-away bin at Barnes and Noble yet.  Jim seemed to tell us a lot about his resume in that book, and not much about currencies, in my humble opinion. 

Here is what I wrote about the fake currency wars back on February 8th, 2013…

Of course adding to the “Currency War” scare pieces of late you have probably seen the invocation of…wait for it….wait…be ready to be scared...“The 1930’s all over again!” Sorry Yogi.

Oh really. “The 1930’s again?” I like what Niall Ferguson wrote about the phony “Currency Wars” a couple of weeks ago in the Financial Times:

“Back in the 1930’s it was obvious who was waging a currency war. Before the Depression, most countries had been on the gold standard, which had fixed exchange rates in terms of the yellow metal. When Britain abandoned gold in September 1931, it unleashed a wave of competitive devaluations. As economist Barry Eichengreen argues, going off gold was the essential first step towards recovery in the Depression. Floating the pound not only cheapened British exports; more importantly, it allowed the Bank of England to pursue a monetary policy focused on domestic needs. Lower interest rates helped generate recovery via the housing market.

 “Today, however, we live in a world of fiat money and mostly floating rates. The last vestige of the gold standard was swept away in August 1971, when Richard Nixon suspended the convertibility of the dollar into gold. For one country to accuse another of waging a currency war in 2013 is therefore absurd. The war has been going on for more than 40 years and it is a war against all of us.”

Central banks (CBs) are delusional in their belief that they can wonder off into a fantasy land of monetary madness and it not lead to some type of blowback.  

The crush out of EM currencies on the back of a relatively small increase in market yields shows just how hooked on credit these countries must be and how desperate for more they must be in a world of tepid aggregate demand.  This has boom-bust written all over it.  We have seen it many times before.  Here is how George Soros defined it in Alchemy of Finance, circa 1987:

The connection between lending and economic activity is far from straightforward (that is, in fact, the best justification for the monetarists’ preoccupation with money supply, to the neglect of credit).  The major difficulty is that credit need not be involved in the physical production or consumption of goods and services; it may be used for purely financial purposes.  In this case, its influence on economic activity becomes problematic. For purposes of this discussion it may be helpful to distinguish between a ‘real’ economy and a ‘financial’ economy.  Economic activity takes place in the real economy, while the extension and repayment of credit occur in the financial economy.  The reflexive interaction between the act of lending and the value of the collateral may then connect the ‘real’ and the ‘financial’ economy or it may be confined to the ‘financial’ economy.  Here we shall focus on the first case.

A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness.  In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible.  That is why the expansionary phase is slow to start with and credit remains soundly based at first.  But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values.  The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy [this may be precisely where the EM markets are now in this process as evidenced by the chart above showing the number of units of credit to produce a unit of gdp growth].  By the that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values.  Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous.  That is the anatomy of typical boom and bust.

To taper or not to taper, that is the question. [My apologies to Bill…]

 

For information regarding the Black Swan Forex Service, please click here.

Thank you.

 

-Jack Crooks

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As usual, we're ahead of the curve: The China-Japan Parallel

[Click here to read the PDF]

John Ross (aka JR) sent me a piece of research this morning from Trading China, titled, "China risks following Japan into economic coma."  The first paragraph of the piece read:

After decades of emulating Japan's export-driven economic miracle, China appears in danger of following it into the same kind of economic coma that Japan is trying to wake up from 20 years later. 

Well, I couldn't agree more.  And in fact I would like to share with you more detail on the possibility China follows down the path of Japan by re-printing an article I wrote three years ago, titled, "The Japanese-China Parallel: Eerie and Scary Combined."  This piece was published in the Forex Journal in the August 2010 edition.  

Read on ...

Currency Currents 30 July 2013

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Notes on rebalancing: Chinese consumer demand and the shale gas revolution

We continue to believe that the world is still in need of major rebalancing. 

Global policymakers have faced an onslaught of crises or crisis potential. As such, despite what seems to be happening (a slow market-led rebalancing), they continue to revert to policies that have driven growth (and imbalances) in the past. 

A true rebalancing will bring economic pain, for sure. But the ongoing resistance we're seeing will only mean the pain is deeper and lasts longer whenever it comes.

Of course, China is a big part of the rebalancing puzzle. And they've acknowledged their need to rebalance their economy. They've even taken concrete steps to insure they pull back from the growth path that leads to an overheated economy and an inevitable collapse.

Measures to increase the number of transactions in their own currency, the yuan, are encouraging. The greater the use of the yuan in global trade the more open it must become and the better the market can dictate its value. 

We consider currencies to be the pressure valves of economies that serve to rebalance respective economies as needed. A system with an explicitly managed currency (e.g. China) or implicitly managed currency (e.g. US) cannot be good in the long-run.

But certainly there are risks to China even as it embraces some pieces of rebalancing.

Many analysts and researchers note the demographic hurdle. As much as China is urging its population, directly and indirectly, to become more urban, the needed and expected shift cannot be forced. Consider the real estate market, for example ...

The inventory of housing is in place now, but most of China's rural class and commuting class cannot afford to live there. A significant drop in price is needed to help this along. But with a significant drop in price comes a drop in wealth for those investors who've bought into the housing developments and the real estate market in general. 

When you see a system-wide erosion in wealth you often see contagion in credit markets. China's shadow-banking system (i.e. unconventional loans and wealth management products) has expanded amidst the last couple years of stop-and-go lending policies passed down by the government and the PBoC in response to inflationary pressures. When the value of assets drops and borrowers begin to default, the rest of the dominoes become more vulnerable.

In China's commie-capitalist economy, the leaders maintain their grip on the economic reins. But not only do they claim credit for the good, they must also deal with the bad and the ugly. 

Rebalancing will require reforms that hand over greater control to Chinese households and consumers. This means the policies that brought years of double-digit growth must be sacrificed to some extent. This is why the task of rebalancing China is oh so delicate -- necessary reforms equal lower growth, but lower growth equals socio-economic tensions. Unfortunately, the tension will come a lot more quickly than the benefits of reform.

There is a reason I dug into this today -- I came across two articles this morning ...

The first simply notes some recent improvement in Chinese consumer demand and factory orders. Here is Reuters' takeaway from the numbers that were reported:

Stronger domestic demand helped China's factory activity to rebound in March, with... new orders up sharply in a sign that the underlying economic recovery is strong enough to weather any risks from patchy export performance .

This is certainly a welcomed development amid ongoing Eurozone woes that have kept China's best export customers at bay. But is it enough to keep the economy going if Europe triggers a quake in financial markets?

The second article I came across this morning represents a bigger story that attempts to look further into the future of China's factories. More specifically, the US shale gas revolution is likely to facilitate some rebalancing in China as it reduces the costs of producing goods in the US. This is certainly a long-term data point, but it gives merit to that arguement that "Made in the USA" will make a comeback.

Here is a key piece of the Reuters' column titled, "Will shale gas decimate China's toy makers?":

The advent of cheap natural gas in the U.S. is threatening to displace expensive naphtha in the production of petrochemicals, the key building blocks for plastics, synthetic fibres and solvents and cleaners.

There was a story in The Atlantic earlier this year that talked about GE bringing factories back to the US. The simple reason is that it makes more sense to have a better grip on all stages of production and supply chain management. Consider also the fact that Chinese wages and transportation costs have risen.

And then recently I saw comments from the CEO of a major US company who said the cost of labor is not the primary reason for taking a company offshore; the regulatory and tax environment are the main reasons. If the US government finds ways of lessening this burden, and the shale gas revolution lives up to the hype, America could quickly see a manufacturing renaissance that changes global trade dynamics quite drastically.

 

-JR Crooks

Comment

China's debt-to-GDP is "unsustainable," say Nomura chief economist.

I came across this article today: Australia warned of future China crisis double whammy

I don't think China's debt is already at unsustainable levels. But I do think the make-up poses a huge risk. Further research uncovered lots of good recent articles on the topic. Here they are ... and why I think they matter:

With 1) the potential for Chinese inflation to increase in an environment of perpetual global monetary stimulus and renewed capital inflows, plus 2) the potential Cyrpus will spark a downshift in eurozone growth expectations and a crisis in confidence, China's financial system and debt could quickly become an issue that influences financial markets at a very inopportune time.

-JR Crooks

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Part III: Real Reform Unleashes an Asian Consumer Boom & Enhances Chinese Power

The first major implication of the major powers competition between the US and China is the currency impact.  China attempts to internationalize its currency and reduce the relative share of the US dollar in global accounts will likely shift into overdrive as result of this competition.  There is nothing like a structural shift out of the old hegemon's currency to prove there is a new power on the block a la the dollar edging out pound sterling.


Will China travel down the reform path?

 Currency Currents 13 March 2013

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