The King of Dollar Pegs

by Doug Noland

November 28, 2014


Collapse of the "global reflation trade" runs unabated.  Where might contagion strike next?

On the back of OPEC’s failure to cut production, crude this week sank $10.36, or 13.5%, to the lowest price since May 2010. The Goldman Sachs’ Commodities Index (GSCI) dropped 8.2%, to the low since September 2010. It’s worth noting that Copper dropped 6% this week to the lowest level since July 2010.

On the currency front, this week saw Russia’s ruble slammed for 7.3% to a record low. Brazil’s real dropped 1.9%, the Colombian peso 3.2%, and the Chilean peso 2.3%. The Mexican peso fell 1.9% to the lowest level since the tumultuous summer of 2012. The South African rand declined 1.1%. And despite losing a little ground to the euro this week, the U.S. dollar index traded to the highest level since June 2010.

At the troubled “Periphery of the Periphery,” Russia's 10-year yields jumped 43 bps to 10.53%. Ukraine 10-year yields surged 297 bps to a record 19.49% (Bloomberg: “worst week on record”). Venezuela CDS jumped 188 bps to 2,292. Greek 10-year yields surged 42 bps to 8.35%.

The melt-up in global “developed” bond markets is nothing short of incredible. German (0.70%), French (0.97%), Italian (2.03%), Spanish (1.90%), Portuguese (2.84%), Austrian (0.84%), Belgian (0.92%), Irish (1.38%) and Dutch (0.82%) yields all traded to record lows this week. With GDP surpassing 130% of GDP, Italian 10-year yields at 2%? French yields below 1% - with a huge debt load and big deficits as far as the eye can see? Japanese yields at a record low 0.41% (federal debt-to-GDP exceeding 250%)?
 
What on earth have central bankers done to global markets? It’s worth noting that U.S. long-bond yields Friday fell below the October 15th “panic low” level, closing at a 19-month low 2.89%.

Market divergences have turned only more extreme. This week saw the S&P500 trade to another all-time high. The Dow Jones Transports jumped 1.1% this week to a record high.

Gaining 2.0%, the Nasdaq 100 traded to the highest level since that fateful month, March 2000. Biotech stocks traded to a record high. The Morgan Stanley Retail Index jumped 2.0% this week to close at a record high. Standard & Poor’s Supercomposite Restaurants Index gained 1.3% to also close at an all-time high. In (“Core”) EM, the Shanghai Composite traded to a three-year high, while Indian stocks closed Friday at a record high.

It’s worth noting that the last time crude, the GSCI and copper traded at today’s levels the Fed’s balance sheet was about half its current size. Ditto for Bank of Japan assets. China’s International Reserve holdings have increased more than 70% since June 2010 (to $3.888 TN). Total Chinese system Credit has almost doubled in five years. Debt has exploded throughout EM, with too much denominated in dollars.

The world is now six years into history’s greatest concerted monetary inflation. Unprecedented policy measures have incited an unmatched global speculative Bubble. There is the ongoing global securities market Bubble that inflates on the back of central bank liquidity pumping and market backstops. This week, however, provided added confirmation of the ongoing deflation of the “Global Reflation Trade.” I believe history will look back on the crude, commodities and EM currency collapses as warnings that went unheeded in manic securities markets. In the worst-case scenario, the faltering of the global Bubble at the Periphery ensures that central bank liquidity stokes “Terminal Phase” excess at the Core. The global monetary experiment is failing spectacularly, though over-liquefied securities markets remain in denial.

November 28 – Financial Times (Jamil Anderlini): “ ‘Ghost cities’ lined with empty apartment blocks, abandoned highways and mothballed steel mills sprawl across China’s landscape – the outcome of government stimulus measures and hyperactive construction that have generated $6.8tn in wasted investment since 2009, according to a report by government researchers. In 2009 and 2013 alone, ‘ineffective investment’ came to nearly half the total invested in the Chinese economy in those years, according to research by Xu Ce of the National Development and Reform Commission, the state planning agency, and Wang Yuan from the Academy of Macroeconomic Research, a former arm of the NDRC. China is this year on track to grow at its slowest annual pace since 1990, and the report highlights growing concern in the Chinese leadership about the potential economic and social consequences if wasteful investment leaves projects abandoned and bad loans overloading the financial system. The bulk of wasted investment went directly into industries such as steel and automobile production that received the most support from the government following the 2008 global crisis… The bulk of wasted investment went directly into industries such as steel and automobile production that received the most support from the government following the 2008 global crisis…”


November 23 – Reuters (Kevin Yao): “China’s leadership and central bank are ready to cut interest rates again and also loosen lending restrictions, concerned that falling prices could trigger a surge in debt defaults, business failures and job losses, said sources involved in policy-making. Friday's surprise cut in rates, the first in more than two years, reflects a change of course by Beijing and the central bank… Economic growth has slowed to 7.3% in the third quarter and policymakers feared it was on the verge of dipping below 7% - a rate not seen since the global financial crisis. Producer prices, charged at the factory gate, have been falling for almost three years, piling pressure on manufacturers, and consumer inflation is also weak. ‘Top leaders have changed their views,’ said a senior economist at a government think-tank involved in internal policy discussions. The economist… said the People’s Bank of China had shifted its focus toward broad-based stimulus and were open to more rate cuts as well as a cut to the banking industry's reserve requirement ratio (RRR)…”


China has been somewhat off the markets’ radar of late. The People’s Bank of China has been injecting large amounts of liquidity and, last week, cut interest-rates. Chinese stimulus these days feeds the bullish imagination. Chinese equities have rallied sharply (short squeeze?), and the bulls view this as confirmation that China’s policymakers have everything under control.

At this point, I view China as a real near-term wildcard. Inarguably, both Chinese end demand and finance were integral to the “Global Reflation Trade.” Supposedly, the Chinese boom was to provide robust commodities demand for years to come. Chinese companies have scoured the world for commodities-related investment. At the same time, the Chinese financial system played a major role in global commodities financing. What does the commodities collapse mean for Chinese financial stability, especially with stability already challenged by serious domestic issues.

I find it intriguing that Chinese policymakers have apparently turned much more concerned about the economy (see Reuters excerpt above). And a report (see FT above) from government researchers has admitted that “government stimulus measures and hyperactive construction… have generated $6.8tn in wasted investment since 2009”? Wow. I’ll assume that Chinese officials are now in intense discussions as to how to respond to a bevy of pressing issues, including sinking commodities, heightened global disinflationary forces, king dollar, significant currency devaluation from the Japanese, Europeans, South Koreans and others, and overall mounting financial and economic risks.

Over the past six years, respective U.S. and Chinese Credit Bubbles have been engaged in somewhat of a mirror image dynamic. With U.S. federal debt up 150% in six years and the Fed’s balance sheet inflating 400%, surfeit dollar balances flooded into the PBOC. In the process, the People’s Bank of China accommodated a historic expansion of Chinese domestic Credit. This Credit fueled historic booms in manufacturing capacity and Chinese housing (apartments). This Credit Bubble was also fundamental to the greater EM Bubble that saw virtually unlimited cheap finance spur booms throughout the commodity-related economies.

Importantly, this powerful self-reinforcing U.S. to China to EM (“global government finance Bubble”) dynamic was possible because of the Chinese currency’s tight link to the U.S. dollar. This “peg” ensured that when finance flowed into China it would be easily converted into local currency balances at the PBOC, and then immediately recycled back to U.S. securities markets. The King of Dollar Pegs also created a powerful magnet for speculative flows. Why not borrow cheap and invest in higher-yielding securities (or finance commodities) in a currency tied to the dollar? Better yet, between June 2010 and January of this year the Chinese steadily revalued the renminbi higher against the dollar. In the past I referred to the renminbi/dollar as a “currency peg on steroids.” It made the SE Asian currency pegs from the nineties look tiny and feeble in comparison.

I all too clearly remember the bloody havoc unleashed when currency peg regimes collapsed back in the nineties. Part of the current bull case is that the world has largely moved to free-floating currencies, with EM central bankers sitting on huge treasure troves of International Reserves. And China’s massive $3.8 Trillion of Reserves has the world believing they have ample “money” to spend their way out of any predicament, certainly including pressure that might befall its currency.

I just believe we’ve reached the point where the renminbi peg to king dollar has turned quite problematic for the Chinese. Actually, it’s my view they have recognized this for a while now, and actually decided early this year to begin an orderly currency devaluation. And between late-January and into early-May, the renminbi was devalued about 3.5% versus the dollar (to about 6.25 per $). Yet they then reversed course, with the remninbi trading back down to 6.11 this month. I’ve pondered whether policymakers turned timid after renminbi devaluation prompted a problematic reversal of “hot money” flows and heightened stress in their huge commodities financing complex.

Over recent weeks, increasingly desperate measures from Draghi and Kuroda spurred king dollar, in the process pushing crude, commodities and EM currency markets over the edge. While U.S. equities investors are salivating over the thought of sinking energy prices, a deflating commodities complex has myriad negative ramifications. For one, the “hot money” exit from commodities and commodities-related economies has accelerated. This ensures serious Credit issues after years of financial and investment excess, with negative economic effects for EM generally.

These dynamics now place China in a real bind. Already suffering from massive overcapacity, slim profits and heightened financial stress, Chinese manufactures are now exposed to a severe global slowdown and acute pricing/competitive pressures. The bloated Chinese financial sector could be even more vulnerable. Keep in mind that Chinese bank assets are projected (Autonomous Research’s Charlene Chu) to end 2014 with assets of $28 Trillion – an astounding triple the level from 2008. And don’t forget the now substantial Chinese “shadow banking” sector that has apparently been a bastion of high-risk lending.

God only knows the mess that’s been created. Chinese finance was already facing the downside of both a historic housing Bubble and an unprecedented over-/mal-investment throughout the manufacturing complex. Throw in a global collapse in commodities and the bursting of the EM Credit Bubble, and one is left fearing for Chinese financial and economic instability.

I believe Chinese policymakers have major decisions to make. Do they stick with the peg to king dollar? Increasingly, it doesn’t seem tenable. With the way global dynamics are now playing out, divergent U.S. and Chinese economic structures are inconsistent with a stable currency peg. The (consumption and services) U.S. economy, with its relatively small export sector, is less sensitive to the global commodities downturn and economic slowdown. The U.S. financial sector is less directly exposed to global commodities and EM instability. Perceived economic and financial stability – in the face of a now deflating global Bubble – throws gas on the king dollar fire.

Meanwhile, the Chinese economy and financial sector appear more vulnerable by the week. To this point, sticking with The Peg has likely held financial instability at bay. At some point, however, I would expect priority to be given to China’s massive export sector and the challenge of maintaining full employment (and social stability). I believe it will prove difficult for the Chinese not to devalue. This week saw the renminbi decline 0.33%, the largest weekly drop since April.

Curiously, Chinese International Reserves dropped $81bn in September – and are now down $106bn from June highs. How much “hot money” flowed into China over recent years, enticed by the Chinese “miracle economy,” by high yields, by global liquidity excess and a currency tightly linked to the U.S. dollar? But with the China story turning sour and the temptation to devalue on the rise, why would “hot money” not be looking to exit? Has an important reversal in speculative finance already commenced? Might this have marked a momentous inflection point for the Chinese and global Bubbles? How stable is The King of Dollar Pegs? What are the ramifications if it falters - for Chinese financial stability, for commodities, for EM, for the global economy and global Credit? Could the escalating risk of a destabilizing unwind help explain the simultaneous collapse in global commodities prices and “developed” sovereign yields?

With global “hot money” now on the move in major fashion, it’s time to start paying close attention to happenings in China. It’s also time for U.S. equities bulls to wake up from their dream world. There are Trillions of problematic debts in the world, including some in the U.S. energy patch. There are surely Trillions more engaged in leveraged securities speculation. Our markets are not immune to a full-fledged global “risk off” dynamic. And this week saw fragility at the Global Bubble’s Periphery attain some significant momentum. Global currency and commodities markets are dislocating, portending global instability in prices, financial flows, Credit and economies.

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