Euro Comments [and China] in Front of the Fed

Euro Comments [and China] in front of the Fed:

Should we just shut down our trading screen till Wednesday afternoon in expectation of a couple of days of backing and filling and intraday volatility in front of the Fed? Maybe! Despite the recent rally move in the euro, which as I said surprised me, I still believe the trend is down. The drivers are varied and linked and include:

  1. yield differential
  2. growth
  3. politics
  4. China slowdown (not necessarily crisis)

Here is an excerpt from the Financial Timesregarding Germany’s growing exposure ad China slows:

As China’s stock market sinks and its economy slows these deep trade links are an increasing source of concern in Germany: Europe’s biggest economy is reliant on exports and has been a particular beneficiary of China’s sustained boom.

But having expanded by 11 per cent last year, German exports to China increased by a modest 1.4 per cent in the first five months of this year.

German machinery exports to China fell 5 per cent in the first half of 2015 and Volkswagen and BMW’s car sales in China have started to wane. German auto, engineering and chemical stocks have tumbled.

The recent rally in EUR/USD likely shook out a decent number euro shorts in front of the Fed. Why should the Fed hike and strengthen the dollar even more in a world where manufacturers are fighting tooth and nail for global demand (and the US current account is widening again)? It is a good argument. We have seen soft data going into the Fed meeting this week; that in turn likely reduced overall the long dollar positioning as Fed hawkish sentiment turned down.

A survey of economists now expects the Fed to remain on hold, though only by a small margin according the Wall Street Journal. There is stridency on both sides ofthe hike argument. I think a hike is warranted. Not on the grounds of overwhelming US job market strength of inflation concerns, but on the belief the low rates have hindered the real economy more than they have helped. But here is the rub: Even if we guess right on the Fed, we still don’t know how the dollar will react. There seems enough doubt in the air to suggest it won’t be a surprise if the Fed passes on a hike this meeting. The non-surprise may already be in the price. Thus, the dollar path may all come down to the reaction players have during Fed Chairman Yellen’s scintillating press conference.

The near-term rally in the EUR/USD can be counted so far as a completed three-legged corrective rally.

EUR/USD Hourly [last 1.1320]: Obviously there is scope for this rally to continue higher and still be corrective; but in terms of symmetry and time it has met that objective.

EUR/USD Daily/DAX Inverted/2-yr Spread: Wave IV complete now in major V down?

EUR/USD Weekly: A case can be made the low at 3 is the low. We have to be open to that view. But if that is the low it means the dollar bull market from 2008 is complete. I am still not seeing that with the potential for a lot more global rebalancing, i.e. deleveraging still needed. We are still not quite sure just how inverted China’s balance sheet may be.

We don’t really know how much corporate borrowing was leveraged to commodities, or real estate, or the US dollar. When the boom was in full swing in China these types of borrowing were all things which helped juice growth on the upside—rising prices boosted collateral values and a falling US dollar drove higher prices. But this same exposure cuts both ways and when growth falls it is accelerated by this same exposure, i.e. inverted balance sheets [thus the soaring debt in China to cover needed cash flow shortages as global demand remains stagnant].

A crisis can be avoided in China. But it means GDP growth will have to decline much further and we need to see a major wealth transfer to the household sector. The idea that China has to juice investment growth, as suggested by some analysts, is exactly the wrong medicine for the “massive overhang of capacity in manufacturing” disease to which China is suffering.

The key for China will be to slowlywork off the leverage (malinvestment) and grow much slower, (thus do not expect non-food commodities demand to return to the levels we have seen before in this lifetime), but at the same time continue to push wealth into the household sector; this will be evidenced by consumer income rising faster than China’s GDP. Rising consumer income, regardless of GDP growth in China, is what will maintain social order and build the type of balanced economy China needs; and be good for everyone.

China’s leadership knows exactly what needs to be done; some of this is implicit in the announcement for more efficiently managing State Owned Industries (SOEs) this weekend. But the vested interests who became wealthy on the past growth cycle, which was investment driven, will continue to pushback hard. These are the same people who have the ability to move a lot of money out of China at a time when China needs liquidity. I would suggest to these people that they stay out of high rise apartments in China. Many of the rich and powerful in China have for some reason been slipping out of windows over the past two year during Xi’s reform drive.

To give you a framework to follow this in real time, keep in mind there are three drivers of growth for a country:

1. Domestic Consumption 2. Domestic Investment 3. Trade Surplus
China’s number 1 (above), Domestic Consumption, relative to GDP is the lowest penetration in history—really off the charts in terms of historical comparison even for developing countries who have witnessed growth miracles.

China’s number 2, Domestic Investment, relative to GDP has been massive during the last 10-years. And this has been the big driver of growth. But, now the relative payback for more investment, given over supply, is much lower than before. And depending on the nature of this investment can be counterproductive to rebalancing.
China’s number 3, Trade Surplus, is fading as global demand remains stagnant since the credit crunch, which means any attempt to boost exports, means China is looking to steal another country’s demand; as Japan has done with its massive devaluation of its currency of late (Japan Current Account vs. USD/JPY next page):

But precisely because of this, China may make a mistake in devaluing it currency for export competitiveness (a falling currency will hit Chinese consumer wealth – below).

Despite the falling global demand as stated, the Chinese trade balance with the US (next page)
continues to grow. At some point the US will say this has to stop and take action, adding another element to risk for Chinese rebalancing that is delayed.

[By the way, where is the so called “exorbitant privilege” of the US dollar status in this trade imbalance—and all the others? Thedollar asworldreservecurrencyisan“exorbitant cost” for the US; it is no privilege whatsoever. The US would be much better off if another country takes of reserve status of the IMF or some other global institution, creates a monetary unit to settle global trade [sadly the US and Harry “Red” Dexter White outgunned (politically only) John Maynard Keynes at the Bretton Woods conference—a Bancor would have sure been a better solution than the US dollar as a global trade monetary unit when it comes to imbalances]. So the next time some clown tries to scare you about “US global currency reserve status being threatened,” and how nightmarish that will be for the US, tell him he is very wrong and is clueless about the global monetary system.]

China mistakenly provided massive stimulus—adding manufacturing capacity—just after the credit crisis in the belief global demand would rebound; this investment represented the growth spurt we saw in 2010, which allowed analysts to believe Chinese growth was back on track and because of this it was China (and emerging markets to a less extent) which would pull the world out of the muck. Let’s be clear here—China is not the global growth engine. A country that imports demand from other countries, evidence by a huge current account surplus, is by definition not a global demand driver.

So, does it make sense for another ramp up in Domestic Investment? Granted, targeted infrastructure projects that enhance household incomes is beneficial, but more investment for manufacturing or real estate is a huge mistake (but this is where the vested interest wants it; in addition to more subsidies for the export sector).

So, it isn’t stimulus per se that will help China. It is wealth transfer that will help China. So rising Domestic Consumption, falling Domestic Investment (for the manufacturing sector/real estate), and a falling Trade Surplus are signs China is rebalancing.

By implication you can see why the path of the Chinese currency is important here. If China does let the currency weaken, it is a nod to the old export model, it means Chinese consumer wealth is declining (because imported goods prices rise when the currency falls in value; think of a currency devaluation as a subsidy to exporters and tax on importers of goods) and delays needed rebalancing.
Stay tuned.