"Periphery to Core Crisis Dynamics"

Doug Nolan


The renminbi traded at 6.8935 in early-Friday trading, with intensified selling pushing the Chinese currency to its lowest level (vs. the $) since May 26, 2017. The People's Bank of China (PBOC) was compelled to support their currency, with the imposition of a 20% reserve requirement on foreign-exchange forward contracts (raising the cost of shorting the renminbi). The PBOC previously adopted this measure back during 2015's tumult, before removing it this past September.

The re-imposition of currency trading reserve requirements indicates heightened concern in Beijing. Officials likely viewed modest devaluation as a constructive counter to U.S. trade pressures. In no way, however, do they want to face disorderly trading and the risk of a full-fledged currency crisis.

The renminbi rallied 1% on the PBOC move, ending slightly positive for the day (but down for the eighth straight week). Trading strongly prior to the PBOC move, the dollar index reversed into negative territory. Many EM currencies moved sharply on the renminbi rally. The South African rand reversed course and posted a 1.2% gain. The Brazilian real also jumped 1%. Curiously, the Japanese yen gained about 0.5%.

Overnight S&P500 futures, having traded slightly negative, popped higher on the renminbi rally. But EM equities were the bigger beneficiary. Brazil Ibovespa index gained 2.3% Friday. It increasingly appears the fortunes of the renminbi and EM markets are tightly intertwined.

The unfolding trade war is turning more serious. Beyond Friday's currency move, China's Finance Ministry - in measures to "guard its interests" - announced plans for significantly broader retaliation tariffs on U.S. goods.

August 3 - CNBC (Michael Sheetz): "China is preparing to retaliate in the escalating trade war with tariffs on about $60 billion worth of U.S. goods. The import taxes would range in rates from 5% to 25%, China's Ministry of Commerce said… There are four lists of goods, one for each of the rates proposed. Many of the goods are agricultural-related, with others on various metals and chemicals. 'The implementation date of the taxation measures will be subject to the actions of the US, and China reserves the right to continue to introduce other countermeasures,' China's release said… 'Any unilateral threat or blackmail will only lead to intensification of conflicts and damage to the interests of all parties.'"

President Trump had already threatened to place tariffs on $200 billion of Chinese goods if Beijing moved to retaliate on earlier U.S. measures. Shortly after the Chinese retaliatory tariff announcement (and post-U.S. payrolls data), Larry Kudlow, Director of the National Economic Council, appeared on Bloomberg Television.

Bloomberg's Jonathan Ferro: "You've sat across the table with the Chinese many, many times. What is your opinion - your insight - into what is happening to the Chinese economy currently?"

Kudlow: "Well, I'm not an expert. I do try to follow it and it looks to me - you all may disagree - it looks to me like the China economy is declining in growth - it's weakening - almost across the board. And it looks like the People's Bank of China is trying to pump it up by adding high-powered money and new credit and so forth. The currency fall is partly [because] they've stopped defending the yuan. They think it's going to help offset the U.S. efforts to get rid of their unfair trading. Some of the currency fall, though, I think is just money leaving China because it's a lousy investment. And if that continues that will really damage the Chinese economy. If money leaves China - and the currency could be a leading indicator - they're going to be in a heap of trouble. And so I'm going to make the case that they are in a weak economic position - that's not a good place for them to be vis-à-vis the trade negotiations - first point. Second point, they better not underestimate President Trump's determination to follow through on our asks - IP theft is a no-go. Forced transfer of technology - no go. Non-reciprocal trading, on tariffs and non-tariff barriers. The President, he's a trade reformer. We've said many times: "no tariffs, no tariff barriers, no subsidies. We want to see trade reforms." China is not delivering. Their economy is weak; their currency is weak; people leaving the country. Don't underestimate President Trump's determination to follow through. I'm just telling you. I can't speak for the Communist Party in China. I can speak for our President. Do not underestimate his determination to change trading practices on a fair, reciprocal plane."

Ferro: "One thing you can definitely speak to, Larry, is the strategy of the President. It just seems to me the strategy of the administration at the moment is to exert maximum pain on the Chinese economy. Is that the direction of travel for you guys, Larry?"

Kudlow: "I would maybe rephrase it a bit. I think what we're saying is we are serious. And in trade, as you well know, your guests know, negotiations often include the use of tariffs. And the President has said time and time again that targeted tariffs are going to be part of the game plan with China - unless and until they begin to meet our requests, which so far they have not. In fact, in the recent month or so we've had hardly any conversations with them at all. There is some hint now that they may wish to talk, although I can't say that with certainty."

The Shanghai Composite sank another 4.6% this week, increasing y-t-d losses to 17.1%. Meanwhile, the S&P500 gained 0.6%, boosting the S&P500's 2018 return to 7.4%. As a large net importer, the U.S. is seemingly less economically sensitive to a trade war than the Chinese economy. U.S. equities have become immune to trade threats. Announcements that would have previously rattled stocks no longer carry much of a punch. As the market sees it, the administration may bluster, but they surely won't risk jeopardizing the great bull market - especially leading up to the midterms.

As Mr. Kudlow stated rather unequivocally, the administration believes it has a very strong hand to play, while China's hand is feeble - and turning only feebler. They have somewhat of a point. The U.S. economy is booming, and our securities markets remain resilient. Meanwhile, cracks in the Chinese Bubble seem to widen by the week. Beijing is feeling the heat. Yet I see important shortcomings in the administration's analysis.

First, I'll be surprised if hardball tactics work on Beijing. For one, the Chinese recognize Trump administration issues go way beyond unfair trade. Negotiations on trade are but the first salvo - so Beijing must be tough and show unflappable resolve. As they see it, give in now and they'll face an unrelenting Washington power play. Display weakness on trade and the Americans would be emboldened to confront Beijing on the South China Sea or Taiwan. Chinese leadership sees the U.S. as trying to contain China's ascent to their rightful place of global power, influence and prestige.

I also believe the Trump administration is overstating the strength of the hand it's playing. The U.S. economic boom has attained significant momentum. Animal spirits are running hot and there remains a potent inflationary bias throughout the asset markets. But I would argue that the U.S. is today much more exposed to a shift in the global financial backdrop than is appreciated in Washington or by the markets. In my view, the unfolding trade war with China poses a clear and present threat to global finance.

The U.S. boom is built on a foundation of loose finance. Finance has meaningfully tightened globally. I'll reiterate my view that the global Bubble has been pierced at the "periphery" - more specifically, within the emerging markets. There are now serious fissures in China's Bubble, a circumstance exacerbated both by EM fragilities and rising U.S. trade tensions.

In this incipient faltering global Bubble phase, instability at the "periphery" has so far engendered somewhat looser financial conditions in "core" markets. U.S. Treasury yields turned sharply lower following the May EM eruption, reversing what had the potential to evolve into tightened financial conditions. Lower market yields, along with looser conditions more generally, incited a rally and powerful short squeeze in U.S. equities.

A critical question going forward: How will evolving conditions at the global Bubble's "periphery" impact the "core"? Recently, some stabilization at the "periphery" has seen waning safe haven Treasury demand. Treasury yields were back above 3.0% this week, before Friday's rally saw yields decline to 2.95%.

Markets remain at this point comfortable that stress at the "periphery" will continue to bolster the "core." This has been, after all, the case in recent years. After beginning 2016 at 2.27%, China and EM instabilities were behind a drop in Treasury yields through mid-year (as low as 1.36%). After a relatively brief pullback early in the year, U.S. equities disregarded global issues as they rallied for much of 2016. Importantly, loose U.S. financial conditions only loosened further, as global Bubble vulnerabilities had the FOMC sitting on its hands for a year between their initial and second "baby step" rate increases.

There remains a prevalent market view that unfolding global instability will have the Fed winding down "normalization" long before rate increases turn restrictive for the booming U.S. economy and securities markets. Besides, any unfolding bout of global risk aversion would ensure booming international flows into U.S. dollar securities markets.

Extended periods of loose finance deeply alter market perceptions, dynamics and structure. Years of QE market liquidity backstops fundamentally changed the way market participants view risk. There is today little concern for trouble at the "periphery" gravitating to the "core." After all, the U.S. has been the primary beneficiary during repeated episodes of risk aversion and outflows from China, EM or even periphery Europe, for that matter.

Indeed, markets have been conditioned to view instability at the "periphery" as an opportunity. It's now been a decade since tumult afflicted the "core." Long forgotten is the traditional dynamic where risk aversion at the "periphery" commences a process of de-risking and de-leveraging - with expanding market illiquidity and contagion. This old market problem was seemingly nullified by activist central bankers.

Well, I believe the current backdrop creates extraordinary risk for a (surprising) reemergence of "Periphery to Core Crisis Dynamics". It's my view that massive global QE measures have for years been responsible for nipping de-risking/de-leveraging dynamics in the bud. The overabundance of cheap global finance ensured a surfeit of market liquidity that would readily accommodate incipient de-risking/de-leveraging at the "periphery." In short, a global "system" awash in "money" ensured de-leveraging dynamics never attained momentum. Contagion risk stopped being an issue - quite a boon for global leveraged speculation. Moreover, even the mildest "risk off" dynamic at the "periphery" would ensure waves of inbound liquidity for the "core." Latent fragilities at the "periphery" were kept under wraps, as global central bankers dragged their heels when contemplating the start of policy normalization.

An analyst on Bloomberg Television made the important point that global QE is today in the neighborhood of $25 billion monthly, down from $125 billion one year ago. Global QE will likely turn negative by year-end. This, I believe, significantly increases the likelihood of an unanticipated return of a destabilizing global contagion dynamic. Rather than instability at the "periphery" doing its usual handiwork to buoy Bubbles at the "core," de-risking/de-leveraging dynamics increasingly have the potential to attain sufficient momentum to negatively impact the "core."

The global liquidity backdrop is in the process of profound - if not yet obviously discernable - change. EM is increasingly vulnerable to a destabilizing bout of de-leveraging in a world of waning liquidity. Thus far, the faltering EM Bubble has incited flows to U.S. Bubble markets.

However, an escalation of the unfolding EM crisis is at heightened risk of inciting a very problematic global de-leveraging - a "risk off" backdrop that would risk piercing vulnerable Bubbles even at the "core." The consensus bullish view - holding EM as a buying opportunity and the U.S. as the mighty pillar of growth and stability - could prove dangerously complacent.

I believe there are great latent fragilities associated with the "Periphery to Core Crisis Dynamic." Distorted markets have over years been conditioned to disregard such risk. I'll presume the administration is simply oblivious, believing it's deftly playing a hand of robust U.S. financial and economic systems. With such a competitive advantage, in their minds there's never been a better opportunity to play hardball and put Beijing in its place.

It's worth noting that 10-year Treasury yields declined four bps Friday. The Japanese yen (up 0.37%) also enjoyed a safe haven bid. Treasuries and the yen seemed to take a different view of developments than U.S. equities.

Friday afternoon Bloomberg headline: "Tit-For-Tat Becomes the Norm as U.S., China Dig In for Trade War." The odds are not small that this Game of Chicken goes unresolved for a while. Clearly, it would be uncharacteristic of President Trump to back down. At the same time, President Xi has shown zero tolerance for any sign of weakness. Increasingly, Beijing is being very publicly backed into a corner (Bloomberg headline: "U.S.'s Kudlow Trash Talks China Calling It 'Lousy Investment'"). Difficult to see China responding cordially.

"Trash Talking" China a few hours after the PBOC is compelled to intervene to bolster the flagging renminbi leaves me uncomfortable. There's a problematic scenario that doesn't seem all that improbable at this point: China faces increased financial instability, including capital flight and de-risking/de-leveraging. The PBOC becomes trapped in the dreadful EM dynamic of bolstering system liquidity in the face of mounting risk of a full-fledged currency crisis. Global markets fret the imposition of Chinese capital controls.

Meanwhile, China instability and trade fears see EM markets take another leg lower, with particular market concern for the highly levered Asian economies. De-risking/de-leveraging dynamics attain self-reinforcing momentum, as contagion effects engulf the global "periphery." Fears of global financial fragility and economic vulnerability see risk aversion begin to gravitate toward the "core." Fears of EM central bank and Chinese selling of U.S. Treasuries overwhelm safe haven buying, as de-risking/de-leveraging dynamics see a widening of Credit spreads and illiquidity begin to impact "core" fixed-income markets.

In such a problematic global scenario, I ponder whether Beijing might perceive it's playing with a relatively stronger hand than their U.S. adversary. Meanwhile, contagion effects would set their sights on the "periphery of the core." It just doesn't seem all that far-fetched.

It's worth noting that Italian yields jumped another 18 bps points this week to 2.93% (Greek yields up 25 bps). And while the Bank of Japan sought to comfort markets with "easy forever," the badly-distorted Japanese bond market is indicating instability. Mainly, it's a problematic market and geopolitical backdrop pointing increasingly to "Periphery to Core Crisis Dynamics." China, EM and the world are now just a disorderly collapse of the renminbi away from, in the words of Mr. Kudlow, "a heap of trouble."

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