The USD Swoons; More Weakness is Likely

The Fed consigned the greenback to another bout of weakness, signalling that easy policy would remain in place for the foreseeable future, and markets were only too happy to oblige, sending the USD index to lows last seen in 2008. We see little on the fundamental horizon that could alter

More Setbacks for Barack Obama, Gold Rises

Gold has rallied today on the back of positive sentiment in equities which we will be attributing to the year-end effect from now on, unless convincing data on the health of the global economy becomes available over the coming period. In particular, that China`s communicated intention to tighten is not dampening risk sentiment is a sign of over-optimism, unless we assume that market consensus regards the cautious nature of China`s rulers as a sign that the proclaimed tightening phase will be mild and brief. We believe that the outcome in this respect is related to the fate of the USD over the coming months as much as it depends on the domestic Chinese situation, and is a lot more uncertain than it is being factored in by the markets for now.

In any case, the Chinese are out of options, if our analysis of the situation is correct, and although we admit that they are by nature cautious about their decisions, our  emphasis is that the nature of the Chinese economy and the political situation at home and abroad does not facilitate the undertaking of radical solutions.

Every one seems to know that China is facing a serious inflation problem at home. Two interrelated causes, among others, cause for this problem, that of hot money inflows, and that of wage pressures as the labor market in the Eastern, coastal regions becomes very tight after years of preferential treatment of the area. It has been reported to be tight for a while, but because Chinese labor has a hard time making its claims heard, serious changes occur slowly. Against this background, the consensus is that the PBOC must raise interest rates to combat inflation, since the yuan is pegged to the USD, but raising rates is ineffective since liquidity extracted by the central bank is more than compensated by foreign inflows that seek to benefit from interest rate differentials.    At the same time, if the PBOC does allow the yuan to appreciate significantly against the yuan, the extremely imbalanced, inefficient, government-subsidized, and export-biased nature of the Chinese economy poses a risk of collapse which the authorities are determined to avoid at all costs.

Against this argument it is often proposed that the growth of the Chinese economy is fuelled much more by consumption that it is generally assumed, and that the observed overheating is caused not to a small extent by much needed infrastructure investment in a country that is still a third world economy in many ways. While a higher target of inflation is acceptable for any developing economy, and infrastructure investment makes sense in a long-term point of view, experience shows that bubbles are likely to develop where there are the most convincing arguments to support them. Rationalizations on the basis of size and capacity do not negate the evidence supplied by the parabolae on many of China`s economic indicators.

It is difficult, also, to justify the belief that China needs so many factories of low added-value products, because  the country has moved out of the class of nations where such products offer the greatest returns long ago, and remains a profitable destination for their producers only because of the government`s policies that artificially maintain consumer incomes at a low level by investing proceeds in U.S. Treasuries, and other external assets. Indeed, that the government is trying to force domestic firms to invest the country`s wealth oversees, instead of diverting these resources to establish a social security system at home is a sign that the Chinese are beyond their limits in benefiting from savings and investment . Finally, there is the limit posed by physical and natural contraints. The northern regions present such a picture of despair in terms of the quality of the environment that even in the highly unlikely case that the Chinese model, and the people`s tolerance for low wages were not exhausted, it appears that the country itself is very close to its limits.

We must wonder, after all, how much it is the wish of the Chinese to see the income level of the population rise rapidly. It is the explicit desire of the CCP that it will hold on to power for many more years to come (official comments place the lifespan of party autocracy between 25 and 100 years.). Assuming that China is no less  susceptible to centrifugal pressures and the desire for freedom than any other country of its size, it is possible that the Chinese government is intentionally pursuing a path that will prevent the income of society from rising too fast in order to prevent the breakdown of social structures that are  sustaining the party`s grip on power. After all, one plausible way of managing the excess liquidity in the country`s system without raising wages or interest rates is to impose and increase labor taxes on profitable companies in order to improve the confidence of the general populace. But the Chinese are not choosing this path either because they are worried about competitiveness, or because they don`t want to see the population becoming too complacent about the future, and thinking about here and now, with predictable unpredictability for the domination of the CCP.

What happens in this country will determine the trajectory of the globe for many years to come, and since the U.S. and the rest of the developed world are sidelined to a large extent due to the implosion of the past years, we believe that the future of China is almost identical to the future of the world economy.  It is arguable, from a purely analytical point of view, with no thought of the human cost, that a quick disintegration of the Communist Party would bring the easiest transition for everyone. But the CCP is not the Communist Party of the Soviet Union, and in spite of endemic corruption and incompetency, it does enjoy the support and enthusiam of a large section of the population, and can show the rising prestige and wealth of the country, even if it doesn`t imply prosperity, as its accomplishments in defense of its legitimacy. In any case, The Chinese probably do not think much about how much better their fortunes would be if they were ruled by a democratic, more competent and responsible government, since the CCP is all that they have.

In news events, the yields of Chinese CDS have risen last week,on the back of speculation that the country will face difficulties as it tries to bring inflation under control. U.S. sentiment was not impacted by the court decision that struck down a key component of the administration`s health care reform plan, but the development does have long-term significance for the markets in terms of the reelectability of the president. Equities, currencies, gold and oil are rallying, and cautious optimism is the theme of the day for today.

U.S. Sues China at the WTO Over Subsidies, Is More to Come?

End of last week, gold was slightly lower against the USD, as oil continued to rise (for which we have few meaningful explanations, especially because high oil prices seem to be on everyone`s tongue nowadays). EURUSD was almost totally unchanged, but the USD was generally stronger against most of its peers.  European bourses underperformed other markets, in contrast to the outperformance of beginning of the week.

Interestingly enough, last week's data releases show inflation cooling further in the U.S, and growth disappointing, coming lower than the consensus 2.5% figure. Excluding the cost of food and fuel, CPI for goods and services rose at the slowest pace since 1959, according to a Bloomberg report.

The deceleration of inflation, which is termed disinflation in economic discourse, is clearly the main theme of this year. For all the endless talk of dollar death, U.S. going bankrupt, the Federal Reserve destroying the American economy, hyperinflation risk, and all the myriad rumors about the imminent demise of American dominance along with the global financial system itself, all that we have to show is the trend in inflation going stretching back to the Lehman Bankruptcy days. There is not a shred of evidence that the Federal Reserve`s actions have brought on the results feared by Congressman Ron Paul, and his Tea Party fellows.

Why is this the case though? As we like to repeat here, it is not because the Fed`s chosen track is the right one, or that the enormous amounts of money created are just evaporating into the air, but only because they are being directed to where there is growth and yield, we do not see the anticipated dollar sell-offs, and inflation. Many who expect the dollar to die are simply out of touch with the fact that the whole world is one market nowadays, and all governments, more or less, are playing the same game according to the same rules, so all are going to lose if the U.S., or any similarly weighty pillar of the system collapses. So when the Fed tries to inflate the economy, and bring down the dollar, the excess created here is absorbed by the Asians into their own bubbles (which the misguided majority believes to be the symptoms of healthy growth), and the USD remains stable, although pointed to the downside. In consequence, although that the USD is going to go down from here is an easy bet, if you do take this choice, you must be careful about  sharp swings.

Readers will be tempted to ask if this gigantic global Ponzi scheme being run by Japan, U.S., China, E.U., and a number of large emerging economies is going last forever. It won`t, of course, but it is hard to say when exactly it will reach its end. One of our favored scenarios foresees the breakdown of economic relations between U.S.-China leading to the end of the global alliance, and in this context, a recent piece of information is worthy of notice.

The Obama administration is planning to widen the front in the incipient stages of the undeclared trade war with China, as the Trade Representative Ron Kirk`s office reports, today, on the filing of a complaint at the WTO over China`s subsidies to its wind power manufacturers. "China’s Special Fund for Wind Power Manufacturing requires recipients of aid to use Chinese-made parts and amounts to a subsidy, both of which violate WTO rules," the statement reads.

The launch of this campaign is just one of a long list of demands by the Steelworkers Union, which had lodged a complaint with the U.S. trade office on September 9th relating to many well-known China-related issues, including export credits, forced technology transfers, discrimination against non-Chinese firms, and many others.

This one issue of wind turbines  is probably being pressed by the administration only as a warning before stronger action will be taken. With the Chinese firmly committed to doing nothing on the currency issue, it seems a matter of certainty that the Obama administration will have to take further action, especially as the election period comes closer and closer. The trade disputes have the potential to eventually create a rift between the two Ponzi partners, China and U.S., and that would of course create the kind of crash that many in the market, including ourselves, are worried about. For now we can do little more than waiting to see, but this is definitely something worthy of close watch, and, as always, we`ll keep our eyes on developments in the region to update you on turning points as they occur, and as we notice them.