So You Think You Can Hike

Sometimes it can be difficult deciding what to write, and other times the Fed hands you your next post on a silver platter.

Headline

Thank you WSJ.

Emboldened by the recent quarter of decent GDP growth, falling unemployment, rising inflation and above all else a soaring S&P 500, the Fed says its ready to hike… just not right now.

“Officials are almost certain to leave rates unchanged when they meet July 26-27, according to their public comments and interviews with officials.”

I’ve already said my piece on the importance of a Fed rate hike for the July meeting.  I believe it is their last chance to hike.

If they truly want to hike, waiting is a massive miscalculation. The data will not be this supportive again.

A large portion of this stock market rally can be attributed to talks of helicopter money arriving in Japan. The Yen has sold off, US credit spreads have fallen, and the market has convinced itself that everything is fine.

Except everything is not fine, just look at the US’s umbilically tied partner in crime – China.

China FAI

At this rate, private FAI could be negative by as soon as July, although I have my doubts we’ll ever “see” a negative number. But according to Worth Wray, that’s not even the worst part.

We are witnessing what happens when the central authority begins to lose control. Much like the US in 2008, the Fed cut rates to zero and still the economy collapsed. During the expansionary phase of a credit cycle the central planners have a lot of control, but it becomes incredibly difficult to stop gravity once it has taken hold.

This also comes at a time when China’s house price inflation appears to have peaked for this cycle. The tier-1 cities have certainly rolled over.

Meanwhile the dollar is rising off its bottom from early may.

Any further strength in the US economy could accelerate the dollar’s rise and put further pressure on the Yuan which hit a 6 year low against the dollar yesterday morning.

USDCNY

All of this comes at a time that China’s corporate bond market is starting to freeze up. This comes after making a 9 year low in January.

China Bond Spreads

Defaults in China are rising quite rapidly. Halfway through the year and we’ve surpassed the previous two years of defaults combined.

These defaults come at a time when short term financing via Wealth Management Products (WMPs) has absolutely exploded. According to Bloomberg:

“In 2015, China’s financial firms raised 158.4 trillion yuan ($24 trillion) — equal to about 230% of GDP — by issuing wealth-management products (WMPs). The amount of WMPs outstanding at the end of the year was 23.5 trillion yuan. The gap between those numbers reflects the fact that most products have a maturity of a few months so funds are rolled over, perhaps several times, over the course of the year.”

China’s financial firms cannot afford a panic in the bond market. They’ve become too dependent on WMPs at a time when bond defaults are rising, and the private sector is losing faith in the economy.

It won’t take a large hiccup to upset this fragile apple cart which makes it difficult to say how long this can truly last. Using 2008 as an analogue, subprime borrowers were defaulting on their first payments back in the spring of 2007 but it wasn’t till the fall of 2008 that the economy truly started to implode.

To wrap up, the financial plumbing of China is under tremendous stress. Any Fed tightening or dollar strength will exacerbate said stress. So the Fed can talk about hiking, which will push the dollar higher, but they cannot actually hike, because they risk setting off the Chinese debt bomb.

US risk assets can and have certainly headed higher on the hopes of a stronger US economy, which is why I recommended back in May buying S&P500 calls above the all time high, because as I put it:

“Firstly, I would like to reiterate the great risk reward opportunity S&P call options provide over the near term. No one thinks we will hit new highs on S&P which makes call options above that level so cheap and a great way to hedge this bullish scenario.”

And maybe I’m wrong, maybe low oil prices combined with a healthier oil sector (now that we’ve had a bunch of defaults) will push the US economy into a higher gear by the end of this year. With the rest of the world struggling to grow, it’s difficult to imagine the dollar not breaking out of its 18 month trading range and we know what that means for risk assets.

So best of luck to our Fed officials. It certainly looks like they will need it.

 

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