Wednesday, 11 March 2015

Currency war - The China Syndrome

"Battle is an orgy of disorder." - General George S. Patton
Looking at the first effects of the QE launch of our "Generous Gambler" aka Mario Draghi and following up on our "Information cascade" prognosis where we stated that central bankers around the world have done the same "marketing" exercise, namely inducing other central bankers to adopt QE, we reminded ourselves in the current "Currency war" of 1979 American Thriller "The China Syndrome" for our title analogy:
"China Syndrome" is a fanciful term—not intended to be taken literally—that describes a fictional worst-case result of a nuclear meltdown, where reactor components melt through their containment structures and into the underlying earth, "all the way to China." - source Wikipedia
Of course our dual reference is linked to our deflationary bias and the rising tail risk of a Chinese currency devaluation which has been impacted as of late not only by the rising US dollar but as well by the global slowdown in demand. China has been trying to offset its credit bubble in a "controlled fashion" and avoiding a "credit meltdown". 

Back in November 2011 we discussed a particular type of rogue wave called the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
Wave number 3 - Currency crisis:

We voiced again our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:
"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."
Our friends at Rcube Global Asset Management  also voiced their concerns in a guest post entitled "A Chinese Déjà-vu?" published on the 17th of December:
"The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US)." - source Rcube
As pointed out by our friends in their long contribution, the current situation in China is eerily familiar with the Asian economies in 1997 particularly when you look at domestic demand which is at its weakest since 1997!

In this conversation, we would like to discuss further this clear 2015 global deflationary "tail risk" as it seems it is becoming more and more a "topic du jour" in the financial blogosphere which we are part of. After all, China might as well embrace "QE" at some point in true "Information cascade" fashion which would trigger a global deflationary "wave" of significant proportion...

  • Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures
  • Lower EUR = higher deflation risk, be careful what you wish for!
  • Central bankers are falling for "Information cascade"!
  • Time to put your contrarian hat on again and go long US Treasuries
  • Final note « Optimism bias » or  how to underestimate Homeownership rates in the US

  • Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures
China just had its second rate cut in three months to offset the effects of disinflationary pressures sent by its economic powerhouse neighbor Japan and now increasing with the ECB's QE. China is trying to work a balancing act of avoiding an explosion of the credit bubble while maintaining sufficient steam in their economic growth.

Unfortunately, we do not think that a "conventional" approach will be sufficient to offset the "Shrinking pie mentality" we discussed in April last year:
"When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.
In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Revaluation of Japanese Yen, a historical lesson to draw: analysis" - Macronomics, April 2014
We also commented at the time:
"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again..." - source Macronomics, April 2014
Of course the start of Europe's own QE program is accentuating the difficulties for China to complete its balancing act and avoid a credit meltdown. To that effect, we agree with Nomura's take from their Asia Special Report note from the 28th of January entitled "Quantifying China's monetary policy" that conventional measures will not be enough to counteract disinflationary pressures now coming from Europe as well:
"• The ECB’s QE program is adding further appreciation pressure on the CNY nominal effective exchange rate (NEER), which by constraining exports and adding to disinflationary pressures, further adds to the likelihood of policy loosening in China.
• The types of monetary policy instruments used will depend on economic and financial conditions. Should net capital inflows surge again, we would expect the probability of four RRR cuts in 2015 (our base view) to fall, but the probability of more benchmark rate cuts to rise (we currently expect one 25bp rate cut in Q2).
The risk, however, is that the monetary policy framework may have changed. Given concerns of reigniting the property and credit market booms, authorities may be reluctant to send strong signals of policy easing through interest rate or RRR cuts, leaving piecemeal, targeted instruments as the PBoC’s new, preferred tools. The authorities have expressed their intention to continue targeted piecemeal measures this year. For example, at the 2015 World Economic Forum, Premier Li stressed that China will pay more attention to policy fine-tuning and better utilising targeted policies to ensure the economy within a reasonable band.
The problem is, however, that the headwinds of deleveraging and the property market correction are so powerful – domestic demand is at its weakest since 1997 – that the economy is unlikely to be stabilised on piecemeal easing measures. Moreover, the potency of stealth-like, piecemeal targeted easing on the real economy has weakened significantly, in our view, even for the sectors (e.g. small enterprises) that the targeted measures are supposed to support.
Should this time window for more traditional wholesale monetary policy loosening be missed, the authorities may eventually be forced to ease more aggressively when the economy is slowing more sharply and edging closer to deflation, adding volatilities to the economy." - source Nomura
Further pressure on CNY nominal effective exchange rate (NEER)? this can be ascertained from Société Générale's Cross Asset note from the 9th of March entitled "Is China the major tail risk for global equity markets?":
"RMB weakness

  • The yuan appreciated strongly over the past ten years. Its recent depreciation has fuelled concerns that China could be about to join the currency war.
  • But in fact, the PBoC has been consistently selling dollars to offset capital outflows and maintain the trading band. A continuation of dollar-selling intervention, rather than persistently raising the daily fixing, widening the band, or outright devaluation, remains our base case scenario
  • Our EM strategists highlight that devaluing the RMB has little economic justification given a robust trade balance, medium-term objectives of rebalancing away from exports to the domestic economy, and could work against internationalisation efforts." - source Société Générale
The issue we have with Société Générale's EM strategists case that devaluating the RMB would have little economic justification in the current "rebalancing" act, is that increasing disinflationary pressures from outside China might indeed lead it to succumb to "Information cascade" as a cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts.

When it comes to China and "Deleveraging", the country is facing yet another "Long March" as indicated by Morgan Stanley in their March 10 China strategy note entitled "China Deleveraging - the long, bumpy ride continues":
"Total leverage to official GDP has risen to 247% at Sept 2014, still rising but at a slower pace than in the 2008-2011 time frame. Our score of progress on 10 dimensions of successful deleveraging drops back to 48 from 51 out of 100, erasing the improvement made in our last review. China’s deleveraging looks set to stay a long and bumpy ride.Scores have fallen most notably in
1) Guiding down real exchange rate; 2) Generating negative real borrowing rates; and 3) Fiscal transfers to low end households and SMEs. We raised scores for 1) better recognition of bank NPLs and, 2) accelerated capital markets development."
The absolute leverage scale has continued growing but its pace has slowed down. Total system leverage amount in RMB has only been growing at 12% YoY in 20143, ~1/3 of its growth during the peak year of 2009 at 30% (Exhibit 4).However, this is in the context of nominal GDP growth slowing.

Among different segments, mid/large enterprises are the only category that has consistently been growing its leverage amount faster than the entire economy since 2011. As a comparison, small business’s total leverage growth has been consistently lagging the overall economy during the same period. We have always argued that de-levering of large enterprises while further levering up the small enterprises is essential for China to achieve a successful deleveraging. Unfortunately this is not really happening. Exhibit 5 shows how mid/large enterprises’ share in total system leverage balance grows while that of the small enterprises shrinks.
On the plus side, the consumer segment has reported meaningful positive development. Total leverage by consumer has been growing faster than total system leverage in 2013 and 2014 (Exhibit 4), and its absolute share in total social leverage has grown from 8.6% in 2012 to 9.6% by Sep 2014 (Exhibit 5).
Local government also shows a minor slowdown in leverage growth in 2014. However the pace is slower than we would have preferred. This is consistent with our view that thorough auditing/quantifying and designation of LGFV obligations would be much more time-consuming than expected." - source Morgan Stanley
The on-going anti-corruption campaign in China has been gathering momentum, yet, the clean-up in the local authority credit binge as pointed out by Morgan Stanley in their report has been slower. We have long been advocating swift and fast restructuring when dealing with bloated balance sheets, a road Europe has not decided to follow hence the "japanification" process, but that is another matter.

In the devaluation case, Morgan Stanley doesn't believe in their recent note would be the right course of action:
"We have long argued that a lower real exchange rate should be part of an overall policy setting (along with fiscal and monetary adjustment) to help China achieve a successful deleveraging. This is because the net export sectors could play a cushioning role during the adjustment process for the broader corporate sector given its leverage problems and entrenched PPI deflation (see the next section). However, a sudden nominal devaluation of the CNY is not necessarily the right course of action or indeed likely to happen. Our baseline scenario sees only a modest and gradual weakening in the fixed parity of the CNY near term, before gradually appreciating back to 6.09 at the end of the year." - source Morgan Stanley
We agree to disagree with Morgan Stanley and side with Nomura and others on the devaluation risk given the weakness in global demand but we give them for now the benefit of the doubt in the light of exports data showing recently a 15% rise in the first two months of 2015, while the value of imports fell 20 by 20%. 

In similar fashion to Europe, could the decrease in imports in China and lower GDP means consumer have indeed less money to spend as well? We wonder.

Another point which is of great interest from the same Morgan Stanley note is the evolution of China's PPI which has fallen to level not seen since the Great Financial Crisis (GFC):
"The rise in the real interest rate has been mostly caused by the recent deflationary trend itself reflecting China’s excess capacity in over-leverage sectors. PPI in China has dropped to its lowest levels since the Financial Crisis. Feb 2015 PPI declined at accelerated rate of -4.8% yoy (versus -4.3% yoy in Jan 2015) whilst CPI inflation modestly edged up to 1.4% yoy (from 0.8% yoy in Jan 2015). Among all Asia EM countries, China has been in PPI deflation for the longest time – 36 months (Exhibit 14). This PPI deflation has been further exacerbated by the recent stagnated commodity prices at a global level.
China’s actual system wide credit costs are higher than official lending rates. Moreover, China’s system wide credit costs are significantly higher than the official lending rate. Our MS China Banks team estimates the overall system wide credit costs of 7.69% at year-end 2014 has fallen to 7.45% at the time of writing after the most recent official interest rate reduction to 5.35%. On this basis we calculate the real interest rate expressed in relation to PPI inflation is approaching 12% significantly above overall real GDP growth with the real interest rate expressed in relation to CPI quite close to current overall economic growth."
 - source Morgan Stanley

The actual system wide credit costs indicated by Morgan Stanley do validate additional rate cuts in the coming months to facilitate the deleveraging and the economic slowdown.

What could arguably put a spanner in the difficult Chinese "rebalancing" act is in our mind the deflationary impulse of the latest QE player being the ECB hence our next bullet point.

  • Lower EUR = higher deflation risk, be careful what you wish for!

In terms of China Syndrome and currency war, we have also read with interest Bank of America Merrill Lynch from the 9th of March entitled "Currency war, ECB QE and deflation risk:
"Lower EUR = deflation risk?
The decline of EUR/USD below 1.10 may be less benign than it may appear at first.
We believe it is likely to exacerbate an exit from EM, increase the risk of an RMB devaluation, place renewed downward pressure on oil prices, and heighten concerns about deflation risks.
In our view, the decline of EUR/USD this week below 1.10 may be less benign than it looks at first glance:
  • Lower EUR/USD is exacerbating the exit from emerging markets (Chart 10). 

USD/TRY hit an all-time high last week (a risky cut, and USD/MXN is within striking distance of its all-time high reached briefly after the Lehman bankruptcy. Even USD/BRL has moved above 3 for the first time since 2004.
  • Lower EUR/USD will likely put more pressure on China to devalue the CNY (Chart 11). 

As we have argued, a CNY devaluation, which would signal which would signal to us that China is joining the currency war, is the biggest tail-risk of 2015.

  • Lower EUR/USD will likely place downward pressure on commodity prices, particularly oil prices (Chart 12). 
Our commodity team continues to think that the balance of risks for oil prices points to further downside given the elevated level of inventory globally (Chart 13).
 - source Bank of America Merrill Lynch
On the deflationary impact of QE which we have discussed in numerous conversations, we read with interest CITI Matt King's 27th of February note entitled "Is QE Deflationary":
"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI
 What we have long posited is that while wanting to induce inflation, QE induces deflation.

In our conversation "Supervaluationism" back in May 2014 we indicated we were in complete agreement with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete
Capital gains in the form of exorbitant bond price? You bet!

Here is a good illustration we think in the meteoric rise of a long Portuguese Government Bond 4.1% maturing on the 15th of February 2045 issued on the 13th of January at par! - graph source Bloomberg:
A nice price increase to say the trading around 134 in cash price meaning risk-free profits on a continuing basis, unconditionally offered to bond speculators thanks to Central banks and their QEs! "Irrational exuberance" à la Alan Greenspan? As we posited in our conversation "Pascal's Wager" bond investors are indeed making a "rational" decision based on the premises that central bankers are "deities".
  • Central bankers are falling for "Information cascade"!
As we posited in our last conversation, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE. The China Syndrome is leading to another form of mimic, this time around currency war as described by Bank of America Merrill Lynch in their 3rd of February note entitled "Currency war and its consequences:
"The unspoken war
There is a growing consensus in the market that an unspoken currency war has broken out. For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate. The reason why this is a war is that it is ultimately a zerosum game – someone gains only because someone else will lose.
Nevertheless, it would seem that policymakers are becoming more open and ready to avail themselves of this last resort. This includes even those of some large and closed economies that are generally thought not to benefit as much from weaker exchange rates as small and open ones. This is not totally surprising given currency devaluation, unlike structural reforms that can also increase competitiveness, is relatively painless and easier to do politically.
How time has changed. Central bankers who are normally reticent when it comes to talking about exchange rates in public are now openly expressing their desire for a weaker currency. Last September, the BOJ Governor Haruhiko Kuroda suggested that “it is nothing strange at all for the dollar to strengthen” and said that he did not believe that “a weakening yen is undesirable for the Japanese economy.” A month before, ECB President Mario Draghi made the case as to why “the fundamentals for a weaker exchange rate [euro] are today much better than they were two or three months ago.”
All this is helping to reduce the stigma associated with currency devaluation in the international policy circles. Of course, respectable central bankers would still insist that currency depreciation is a consequence of their monetary easing rather than a goal in itself. However, evidence suggests otherwise. The ECB’s new asset purchase program is having a much bigger impact on the euro than on Eurozone interest rates (Chart 1) 

and the clearest impact that BOJ QQE has had so far is a boost to the profit margins of Japanese exporters (Chart 2)."
 -source Bank of America Merrill Lynch

  • Time to put your contrarian hat on again and go long US Treasuries!
While it is no secret that we are sitting tightly in the deflationary camp and that our biggest 2014 has been to go long US duration (partially via ETF ZROZ), we have to confide that, as of late, we have been increasing our exposure following the decent pull-back seen during February. As we also indicated previously, our losses on our exposure have been mitigated by our long standing short exposure on JPY (via ETF YCS). With the EUR/USD touching 1.06 levels, we believe it represents an additional deflationary impulse that both China and the US cannot ignore. On that sense we fully agree with the additional comments made by Bank of America Merrill Lynch in their recent note:
"If the recent negative correlation between S&P 500 and USD/EUR (Chart 3) were to hold, a lower EUR/USD could trigger a more generalized risk-off that would benefit deflationary assets including lower long-term Treasuries. Note that the recent back up in nominal yields has been driven by increased inflation breakevens.
The obvious implication is that investors are becoming concerned about the ability of the US economy to cope with the strengthening USD. Even though on a trade-weighted basis the USD is still far from its highs in the mid-1980s or early 2000s, the pace of the USD appreciation over the past half year has been the second fastest in forty years (Chart 4).

Furthermore, even though exports are only 13% of the US economy, 40% of S&P 500’s earnings now come from outside the US. 
The fact that the weakness in manufacturing export orders appears to be spilling over to general manufacturing orders (Chart 5) and the lack of evidence that consumers are spending what they are saving on gasoline are also likely starting to concern investors.
  What is the trade?
Generally, strong US data lead to higher US bond yields and stronger USD, like on Friday after the February NFP came in stronger than expected. However, we are making the case that we are close to the point that the positive correlation between US rates and the USD begins to turn negative – stronger USD leading to higher deflationary risk leading to lower long-term bond yields." - source Bank of America Merrill Lynch
Indeed, we agree with the above. The economy in the US is much weaker than it seems as we posited in our February conversation "While My Guitar Gently Weeps":
"The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP."
We will be continuing to add on our long US Treasuries exposure rest assured in true Lacy Hunt fashion.

  • Final note « Optimism bias » or  how to underestimate Homeownership rates in the US:

On a final note we leave you with Bank of America Merrill Lynch's Home Ownership rate simulations from their Morning Market Tidbits note from the 9th of March entitled "The world against deflation" showing that the decline in the US has been more dramatic than the published data:
"Homeownership rate simulations: We derive a homeownership rate assuming household weights by age group as of 1994. In other words, we only allow for the change in the homeownership rates over time to matter, holding the household age weights constant. Under this methodology, the homeownership rate would have declined to 62.1% last year. Hence, the aging of households added 2.3pp to the homeownership rate since 1994. This suggests that the decline in the homeownership rate thus far has been even more dramatic than the published data suggest." - source Bank of America Merrill Lynch
So go ahead Dr Janet Yellen, normalize this...

"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory." - Sun Tzu

Stay tuned! 

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