The Bank of China raises its rates by .25% in a surprise move, under the guise of controlling inflation as a result of their massive stimulus. This move by China comes on the heels of Tim “Turbo Tax” Geihtner’s jaw boning about the Yuan Dollar peg and how it needs to be adjusted. “Timmy” went further pushing the tried and true hollow sounding, "we're going to work very hard to make sure that we preserve confidence in the strong dollar." So we are back to the strong dollar policy as we continue to print dollars at a faster rate, is anyone left to buy this line? What "Timmy" is pontificating flies in the face of the FED's pronouncements for higher inflation as a stronger dollar would fuel the opposite. The amazing thing to me is that as a result of this tiny .25% raise it is seen as Dollar positive, as opposed to posturing prior to the upcoming G20 meeting. There are rumors(which is all they are) that the rate raise is part of a deal that was brokered where the Chinese would raise rates and allow the Yuan to strengthen if the US agrees to limit QE. This is pure speculation that is driving this; in fact just this morning the FED's Lockhart is contradicting this by stating that the FED's next QE has to be BIG.
It is blatantly obvious that China has decided to “throw the dog a bone” to avoid negative press from the G20 media blitz. I mean really, what happens to the Dow or NASDAQ when the FED raises by that amount, that’s right, virtually no reaction. To some this is viewed as a suggestion that there is going to be cooperation in the currency markets, I for one doubt it since we have seen this before…talk is cheap! We see this sort of political theater before every G20 meeting and it ultimately amounts to nothing but cover stories and deflection vehicles for those that need to avoid something uncomfortable like the Chinese and their Yuan peg.
The Yuan is pegged on the order of about 6.6 to 1 Dollar. In fact China has already allowed its currency to rise 2.7% this year, although the article claims that the upside on the Yuan is limited the factors surrounding the Yaun are dynnamic and I doubt the Chinese will sit idly by. So since relaxing the peg the Yuan has gotten more valuable while the Dollar has been the inverse.
The rate increase in China is being viewed as Dollar positive why? Oh I see it will become cheaper for the Chinese to import all the manufacturing from the US and help the Dollar and the trade deficit. Really does anyone believe that load of malarkey? If anything China raising rates should be Dollar negative. US interest rates are basically zero bound in a country with massive deficits, questions as to fiscal responsibility and solvency without printing money. The FED has telegraphed officially that they plan to implement QE2 and we can all argue as to the degree of QE that will be officially told, however, the FED is an opaque organization. The FED has been less than open as to what it actually does and reports; going as far as blocking FOIA (Freedom Of Information Act) requests and not stipulating where and to whom bailout money went. Does anyone really believe that the FED will stand by the official QE stance especially if the economy slows or there are signs at least in the FED’s mind, of deflation.
So as the old adage says money flows to where it is treated best and one could make a very compelling argument that it is being treated far better in China then under current US policy. The higher rate of interest obtainable in China should drive money to find a home there as opposed to parking it in the US at lower rates, especially given that China is a trade surplus nation. In the past it may not have even been considered an option but China of today is far different after more than a decade of economic growth. Money moving in to China seeking yield and other assets will only help to fuel China’s growth and serve to effectively starve off capital from the US. If money does flow in to China this will effectively weaken the Dollar even further and since there will be even less buyers of low rate US debt the FED will have to step in and monetize the bonds necessary to keep the government functioning. The last figure I saw was that the US currently depends on the kindness of strangers for roughly $3 Billion a day to keep the game going.
As I type this the US Government is crowding out the private sector for access to capital and is eating the golden eggs the goose produces. If the Chinese incrementally keep raising rates over a period of time and at a rate that does not impede their economy, the US Government will be forced to completely crowd out private investment in the US to fund their deficits, effectively forcing the Golden Goose to be served up on a platter. So rather than viewing the rise in rates in China as a positive I believe that while the market does not always act rationally once the news is digested and viewed in the context of longer term it will be yet another coffin nail in the Dollar. The Dollar has bounced on the heels of this news and will probably do so for the next couple days, but I do not feel that the Dollar’s sudden bounce negates the down trend that is firmly established. Sure there was an extreme in dollar bearishness that fueled this bounce, but that pessimism can turn very quickly and is probably not the best source for a new bull market in the Dollar.
If the reason for the rate increase as is stated is an increase of inflation in China then raising rates is one solution for the Chinese, but they could also allow their currency to appreciate even more than they have. A rise in the Yuan would allow the Chinese to acquire the natural resources they badly need at cheaper prices. Most of the commodities the Chinese are seeking trade around the world denominated in Dollars so by allowing the Yuan to get stronger against the dollar the price of commodities actually declines for those converting Yuan. It also appears that the Chinese have engaged in a somewhat covert move to step away from the dollar by forming agreements with specific countries to trade directly. For example a non Dollar pegged Rupee Yuan deal is sought and there were other deals recently in which China and Brazil agreed to exchanging in the Real and Yuan thus avoiding the dollar.
There are those who argue that there is no alternative to the dollar because no currency is as deep as the Dollar at the moment. I believe that there are alternatives available at present in the form of basket weighting of currencies which would provide enough liquidity, however, I do not believe that we as a world will go the basket currency route. At the moment China is still developing economically and do not have the internal markets to be self sustaining, they are still dependent on exports to keep their economic motor humming, but this is changing. If one looks at history there was a period of time where the US was a huge exporter and we had self sustaining markets; in other words while what happened elsewhere in the world may have affected us it did not cripple us; instead it was viewed the other way around. This gave rise to the saying “When the US sneezes the rest of the world catches a cold”.
The Chinese have both a culture that long range plans and a centrally planned economy. Prior to the rise of the West, for hundreds of years the Chinese were the economic superpower and they as a nation seek to return to former glory. The culture dictates that the Chinese are willing to sacrifice today to get to tomorrow and the centrally planned economy, which has become more flexible over time is their vehicle to get there. The Centrally planned economy has been far from perfect doing things like building entire cities that currently stand empty, but they do appear to learn from mistakes. There are many on this side of the pond that argue the aforementioned point as to why the Chinese will fail to grow, but is our system with a central bank and bloated government that has mis-allocated trillions any better in its current form? I personally do not believe in centrally planned economies. On the other hand if China can continue to form their sort of hybrid of capitalism and centrally planned economy they should fare very well.
So the bottom line here is I believe that the bounce in the Dollar will dissipate after the G20 meeting since no agreements will be reached. There is also a second possibility that we see what I call a fracture in the Dollar system, where the Dollar and gold both go up as has happened in the past. This scenario would be caused by a split of people recognizing saving in gold and spending in dollars. In other words people figure out that they can protect their savings in gold and buy or transact for items in Dollars, kind of a defacto gold dollar peg.
There is no stomach on anyone’s part to endure the pains required to right the system or for those in better shape to give up anything for the common good. Additionally, it appears to me that the “recovery” is already on shaky ground which will not exactly lead to more cooperation. In the mean time I am monitoring the precious metals, commodities, suppliers and “arms dealers” for additions and entry points. We are being given another opportunity to convert those dollars in to “things”, take advantage.