The Yuan Devaluation: Resistance Is Futile

China’s artificial peg is starting to crush its own economy. For a long time China has lived by the sword of its undervalued currency. But now things have changed. The foundations on which it was built rising commodity prices, falling dollar, a growing global economy are all are crumbling.

As I noted back in JANUARY of this year, the Yuan’s artificial peg would create a feed back loop between China and its trade partners. It goes like this: As china slows down, its trade partners like Australia and Canada will also suffer a slowdown. As a result Australia and Canada’s currencies will fall but the Yuan won’t because it’s pegged to the rising dollar. So the disparity between China’s currency and that of its trading partners will continue to grow decreasing demand for Chinese goods which will in turn only worsen China’s economic situation.

To make matters worse, the Fed is threatening the first rate hike in over nine years. Which is what I believe led China to start the process of devaluation. Technically the Chinese haven’t devalued, they are merely lowering the level of support they’ve previously given to the Yuan. And yet, they’ve still managed to burn through $100B in US treasuries in the past 2 weeks alone. There’s some irony here because the Chinese don’t want the Fed to hike rates but via their long term treasury liquidation the Chinese are forcing long term interest rates higher.

What is most interesting about this whole scenario is that the PBoC is doing everything in its power to defend the yuan’s peg to the dollar. Which begs the question why? Why waste important resources (FX reserves) defending what seems like an indefensible position? Why not just let the market take over? Well the obvious answer here is pain, not just for the average Chinese person whose wealth would evaporate in an instant but to the Chinese corporations that have borrowed over $1 trillion to finance their operations. That trillion isn’t in yuan, it’s in dollars, meaning the Chinese corporations have to pay back their debts in dollars which unfortunately is not the currency they operate in. Any significant devaluation would send most of these companies into default and the country into a recession. Obviously this is not something the Chinese government wants.

So for now the PBoC seems content with selling long term US treasuries to defend its peg. It is important to consider the knock on effects of such a strategy. The most obvious is in the short term, higher US interest rates, which for those holding long term treasuries will certainly make you a little queasy.  Higher long term interest rates will hurt the middle to lower end of the housing market since it will be harder for people to get mortgages. I’m not sure how much this matters as the high end market seems to be what really matters. Especially as foreign money continues to funnel in the US. But with the US economy growing at 3.7% in the 2nd quarter it seems like there’s a good chance (>50%) for the Fed to hike rates in mid September.

Will it happen? The Fed has a history of being gun shy and three weeks is a long time for things to go wrong, especially in this environment. If the Fed is insistent on hiking rates, the global equity and bond markets which are already on a knife’s edge will suffer in the run up. I’ve already stated that if the Fed does hike, the world will quickly fall into a recession. So let’s assume they don’t hike which is what a lot of people are assuming (praying). Will it be enough to out shine the shadow of a Chinese collapse? Short answer is no, but I think there will be a strong but short lived rally due to the intense anxiety market participants have over the upcoming decision. That’s it for now.

The End Is Nigh: China Syndrome

It only took 2 seconds to find this image on google. Pretty great huh?

Ever since the great financial crisis of 08/09 every country has been doing what ever it can to keep its head above water. But in their feeble attempts to prevent the inevitable, the major countries have linked their economies like never before. Where we find ourselves now is in a game of chicken where no one wants to go first and bring down everyone else. That was until China’s stock market in rather epic fashion decides to crash and as of writing this is now negative for the year (after being up 60% ytd). The world is now in panic mode because despite the PBoC’s best efforts, Chinese equities are crashing.

Let’s take a step back. Before China’s stock market began it’s meteoric rise, the Chinese real estate bubble was starting to crack. But don’t worry everyone, China has a plan which some people actually believed they could pull off. After all the plan was so simple. China was just going to “shift” its economy from a heavy exporter to consumer based one instead. Yup that’s right folks, after decades of building factories and plants and buying every mineral and commodity under the sun at the cost of trillions of dollars in debt, China was just going to “shift” away from this problem like it was doing the FOOKIN’ electric slide.

In order to start this ridiculous shift and prevent the toppling of it’s real estate bubble the PBoC  started to ease monetary conditions. The cheap money released from these actions didn’t go back into the real estate sector thus continuing the bubble instead it went into the stock market. And for a while the PBoC didn’t seem to care that it was replacing one bubble with another. After all, consumers would have more money from higher stock price. This would allow the economy to more easily transition to a consumer based economy. Sounds like an amazing idea! Why didn’t the Americans think to do that back in 2001 when the tech bubble burst? Oh wait, we did, and the end result was given the name “The Great Financial Crisis”. What name will history label China’s newest debacle that drags the world into the second great depression? Perhaps the GREATEST Financial Crisis? Or How The Fook Did Humanity Get So Dumb Crisis? With logic that makes the tulip bubble participants look like Einsteins, I think the latter would be a good title indeed.

For we are truly off the edge of the map, as the Chinese look down  to find 2 unstoppable bursting bubbles and zero tools capable of stopping the carnage. “Oh crap!” doesn’t do their predicament justice. But their predicament is the rest of the world’s as well. Just like the American housing bubble derailed the world economy so too will China’s double bubble.

The reason why? Because the world’s major economies have never been as fragile as they’ve been in the post-WWII era, perhaps never in history. Remember China was expected to be the growth engine that powers the world. It was supposed to spark Emerging Market demand with it’s new silk road and ridiculously expensive projects like the Nicaraguan Canal which now seem to be a complete and utter pipe dream.

The Bloomberg Commodity Index (pictured above) hit a 21st century low this week. Commodities getting crushed is only the start of the problem as the nations who heavily traded with China were expecting a steady rise in demand but instead are finding that demand is falling and the value of their commodities is crashing. This is a very dangerous cocktail for not just the companies themselves but the banks which lent them money. This is only the tip of the iceberg as the banks that lent the money are not in any shape to take losses.  Any country that was a major trading partner with China, especially commodity producers, are about to take a massive hit, and if it just so happens that their banks are in terrible shape then China’s crash will become their crash. Two of the most obvious countries that come to mind are Australia and Canada who just so happen to have the most indebted households in the world.

Here comes the –WTF Do I Do With My Money Section

  1. Short Australian and Canadian Banks
  2. Short AUDUSD and CADUSD or the reverse go Long USDAUD and USDCAD
  3. Long USDSAR – As the commodity sector gets crushed oil producers with currency pegs look particularly tasty.
  4. Long Treasuries – Deflation is great for the dollar. Times of Crisis are even better. Crashing Commodities are even better for long term rates.
  5. Short the Yuan. The Yuan is significantly overvalued. In the next year or two a devaluation of 50% or more against the dollar is more likely than the percent of devaluation itself. One only needs to look back at the last Asian Financial crisis for such a precedent.

I’ll go into greater detail in upcoming posts on some of these. Until then, good luck and hold on tight. It’s time to get super defensive.