Danielle DiMartino Booth, Quill Intelligence, GERMANY ECONOMIC REUNIFICATION3

Germany’s Economic Reunification — Can China Save the Global Reflation Trade?

Will the real Easter please stand up? Roughly one-in-three inhabitants of our shared planet can tell you that “on the third day” after the crucifixion, Jesus rose from the dead and ascended into heaven. They can also tell you what preceded the crucifixion — the Last Supper. That particular breaking of unleavened bread also happened to be a Passover feast, which marks the Jewish Exodus from slavery in Egypt. Or at least, that’s the version conveyed in Matthew, Mark and Luke. There was blanket agreement among the earliest Christians that what followed the ultimate sacrifice — life itself and new beginnings — should be commemorated. As for the day Easter would be celebrated, time would bring controversy.

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Danielle DiMartino Booth is CEO and Director of Intelligence at Quill Intelligence

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RED GOLD, Yellen, China, currency, yuan, dollar, economy, Danielle DiMartino Booth

RED GOLD: Does China Aim to Dethrone the Dollar?

Is it finally ‘go time’ in the bond market? For the moment, the answer is a strong maybe. The yield on the 10-year Treasury has burst through its 2017 highs and is behaving as if it could hit the 3% threshold, elusive since the taper tantrum of 2013.

If you’re looking for hard guidance in today’s Federal Open Market Committee statement, I’d suggest you tamp your enthusiasm. Janet Yellen has orchestrated the slowest tightening cycle in history, defying even the ‘measured’ pace at which Alan Greenspan tightened which culminated in the housing bubble bursting. The last thing Yellen wants to do at her last FOMC meeting is stir any pot.

As far as the markets are concerned, Yellen has been a smashing success. The stock market has tacked on a neat 70% gain while at 2.70%, the yield on the 10-year Treasury has barely budged. We’re talking about a move upwards of three whole basis points (bps), or hundredths of a percentage point.

But then, neither the present nor the past dictate the stuff of legacies. That, as we wise souls know, is the purview of the future. Right or wrong, the good deeds of yesterday and today can be wiped away in the wink of an eye. That’s the nature of stability. If it lingers too long, it tends to give way to its polar opposite, instability, in what Wall Street recognizes as a ‘Minsky Moment.’ There won’t even be a way to feign surprise when that moment hits given the record low levels we’ve witnessed on every measure of complacency that exists.

For more on Yellen’s legacy, please link to my latest Bloomberg column: It’s Too Early to Judge Janet Yellen.

Did I mention the strong ‘maybe’ in answer to whether the rise in yields was sustainable? The idea that the economy has gained so much momentum it can withstand four rate hikes this year certainly gives one the warm fuzzies. But it’s hard to conjure a scenario that suggests 3% GDP growth will persist into the second half of this year, especially in a rising rate environment.

As one subscriber wrote, “The current projections for four hikes seem preposterous. Given the debt at all levels of the economy, I doubt the economy can stand those interest rates.” I couldn’t have said it any better myself.

The one jury that still remains out is the yield curve. As dramatic as the move in bond yields has been, relative to the ludicrous low rate world we call home, the difference between the yields on 2-year and 10-year Treasury remains south of 60 bps. And forget about a 3% yield on the 10-year. Can we first pierce that level on the 30-year which at last check was 2.97%?

We are not alone in watching the Fed and bond yields for clues about what the future holds. With the yuan at its strongest level against the dollar since August 2015, you can bet the Chinese are glued to their monitors as well. President Xi Jingping pulled a ton of demand forward last year to pull off a glorious 19th Party Congress. Now he’s got to deal with the aftermath as domestic growth slows, interest rates rise and exports are stressed by the strong yuan.

And yet, rumors of the dollar’s imminent death continue to circulate. Maybe the cryptocurrency contingency is right. Maybe the dollar is headed the way of British Pound Sterling. Maybe the Chinese even have designs on being the dollar’s successor. Or do they? For more on this, please enjoy this week’s newsletter:  RED GOLD: Does China Aim to Dethrone the Dollar?

Wherever you may be, wishing you well,

Danielle

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DiMartino Booth, China, Policy, Economy

Dim Sums: A Fork in the Silk Road

Two centuries before Christ and millennia before truck stops, there was Dim Sum along the Silk Road. What, after all, could possibly best tea houses with nibbles to break the monotony of a 4,000-mile journey from Xi’an to the Mediterranean and back?

The tradition of Dim Sum is rooted in the revelation that drinking tea helps the digestion process, which prompted the introduction of bite-sized dishes to stand as accompaniments. It’s easy enough to envision the warm feeling those beckoning tea house silhouettes over the horizon elicited, the same sensation stimulated by the Golden Arches today.

 

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The Sweathogs of Sovereigns?

Welcome Back Kotter, The Sweathogs of Sovereigns? Dimartinobooth.comBefore there was Tony Moreno, there was Vinnie Barbarino.

The 1970s TV sitcom Welcome Back Kotter would make a star of John Travolta and leave the others in the cast behind. For some though, despite the show’s own short-lived success, the Sweathogs will live on in infamy. The “Kotter” in the show title referred to Gabe Kotter, a former remedial student himself tasked with corralling the rag-tag group of slackers affectionately called the “Sweathogs.” Heartthrob Barbarino was the self-assured Italian who led the fictional Brooklyn high school class. Freddie “Boom Boom” Washington was the resident wisecracking jock. Not to be forgotten easily was Juan Luis Pedro Felipo de Huevos Epstein, a self-described Puerto Rican Jew voted “Most Likely to Take a Life.” And finally, there was the venerable Arnold Horshack, whose hyena-like laugh masked that he was the brains of the bunch.

The only serious aspect of the show involved the assumption that the Sweathogs would never amount to anything in life. The hoodlums’ scripted on-air antics certainly backed the perception they were witless wonders. But as predictable plots would have it, Kotter’s faith and dedication ultimately reveal his problematic pupils’ promise and potential.

Judging by the past two weeks, the Wall Street Journal’s headline writers must think that Chinese officials are sovereigns’ answer to the Sweathogs. Here’s a smattering of the smack-down teasers:

‘China’s Currency Communication Suffers a Breakdown’

‘Did China Change the Way it Fixes the Yuan?’

‘China Central Bank Puzzles Investors’

‘China’s Shift in Yuan Strategy Backfires’

‘China’s War on Yuan Speculators Targets Wrong Problem’

By last Friday, readers wouldn’t have been surprised to open their Journal to ‘Currency Controls for Dummies.’ Instead, they got the following: ‘Beijing’s Yuan Policy is Meant to Baffle.’ Chinese policymakers weren’t, after all, bumbling bureaucratic buffoons. Rather, they had planned to manufacture uncertainty all along, kind of like they’d carefully planned to over-manufacture steel rebar and other commodities suffocating the global economy.

The Journal cited people close to the People’s Bank of China (PBOC), a.k.a. China’s Fed, in its reporting. The PBOC had purposefully changed up the way it sets the yuan’s price by “interspersing periods of depreciation with surprise bouts of strengthening through market guidance or intervention.”

The end game: by illustrating that the currency can gyrate like any other that floats freely, demonstrable evidence can be entered into the public record that opens the pathway to an eventual free float and independence from the dollar peg to which it ostensibly remains tethered.

Now who was the wiser, who made the rest of the world work up a sweat?

My good friend and China expert Worth Wray opened a recent report with the following timely quote from President John F. Kennedy: “When written in Chinese, the word crisis is comprised of two characters. One represents danger and the other represents opportunity.”

Any cold war thinkers out there could certainly connect the dots. How brilliant would it be if the Chinese were meticulously orchestrating a free floating currency knowing full well the financial markets are so fragile as to throw the entire global economy into recession? A crisis begets an opportunity to take one more step closer to reserve currency status.

It’s doubtful though that even the Chinese are that adept, though there is a very real and recent precedent to suggest connivery at the highest levels. Recall that the world was poised to absorb the first Fed rate hike on September 17th. What stopped the Fed from pulling the trigger then? That would be the surprise devaluation of the yuan in August. Of course, Chinese policymakers were simply reacting to the reality of the strengthening dollar to which their currency is pegged.

First, a soupcon of background. According to a report by Elvis Picardo, the Chinese economy quintupled in size in dollar terms in the decade to 2013 catapulting it to unseat Japan as the world’s second largest economy. This growth was generated by an export machine: trade between the U.S. and China swelled from $559 billion in 2013 from $4 billion in 1981.

The critical underpinning was a currency that Chinese policymakers held at artificially weak levels thus rendering their goods more competitive in the global marketplace. The dollar first entered the picture in 1994 when the yuan was pegged to the U.S. currency at a level of 8.28 to the dollar. Over a decade later, pressure from its trading partners forced China’s hand. By 2013, the yuan had appreciated to about 6 to the dollar ($1 bought only 6 yuan whereas it had purchased over 8 yuan in 1994).

Yuan appreciation is not all bad if you consider the ultimate goal of the Chinese powers that be, which is to transform the Chinese economy into one that resembles more closely that of the United States. The goal: Consumption and services self-sustain economic growth freeing China of its modern-day manufacturing shackles. Chinese domestic households must have a strong currency if they ever hope to consume their way to economic nirvana.

The problem is reality often collides with even the best laid plans. Transitioning the Chinese economy could not be accomplished in a Shanghai minute. To that end, it was mandated that manufacturing continued to carry its economic weight to ensure a smooth evolution.

Flash forward to last year and it’s easy enough to imagine Chinese central bankers’ increasing discomfort. The dollar was a runaway train of strength as the world prepared for the Fed to go in one direction while the rest of the world, with their faltering economies, pulled in the opposite direction.

It was thus perfectly plausible and no fault of the Chinese, the explanation goes, that the yuan was taken down a peg in August. Financial market panic ensued and sure enough, the Fed stood down.

But as we all know, that was but a momentary stay of execution. The Fed dropped the gauntlet on December 16th pushing the dollar to fresh heights. That’s when things started to get hairy. Chinese policymakers had vowed to ensure that any future devaluation subsequent to August’s initial move would be gradual.

The market had its own ideas.

China’s “reported” economic growth has slowed from the boom-boom days’ rate of 10 percent to this week’s 6.9 percent for all of 2015. The market for its part has rationally begun to price in the need for further yuan depreciation to prop up the slowing economy.

That’s all well and good except for one little thing. The rest of the world is also falling apart as oil prices collapse, which could easily be perceived to be a reflection of the global growth slowdown resulting from the end of the commodity supercycle, which itself was triggered by the Chinese hitting the outer limits of building empty cities and thus being forced to move to a consumption-driven economy.

In economics this vicious cycle that spirals out of control is delicately referred to as a negative feedback loop. Its much more attractive twin sister is the positive feedback loop. In the case of the current boom which is coming to a violent end, the positive feedback loop was catalyzed by the Chinese consuming more concrete in the three years ending 2013 than the U.S. did in the entire 20th century.

Who is delusional enough to believe this set of circumstances could be replicated today given that the global economy is dangling by an unravelling thread spun by central bank stimulus? And why would anyone believe an orderly unwind of this magnitude to be an even remote possibility?

Of course, the conventional wisdom is sanguine. After all, we are assured, China has $3.3 trillion in foreign reserves to guarantee against any sort of disruptive depreciation. As one Chinese official said last week, bets against the yuan are ‘ridiculous.’

Let’s just say my buddy Wray didn’t get to be Evergreen Gavekal’s chief economist by toeing the conventional wisdom line. By Wray’s reckoning, the starting point is a heck of a lot closer to $3 trillion given the enormous sums they’ve had to throw at stopping the currency’s most run from veering out of control.

But it’s not just what they’ve already spent. A third of their reserves are illiquid and cannot be readily deployed in the business of defending said currency.

And then there’s that thorny issue of prior commitments. President Xi Jinping has earmarked $1 trillion to underwrite the “One Belt, One Road” initiative to lift their economy to new heights. The plan’s anchor entails constructing a new Silk Road that builds infrastructure links from China to Europe and the rest of Asia.

We’re talking about what the Financial Times described as “the largest programme of economic diplomacy since the US-led Marshall Plan for postwar reconstruction in Europe, covering dozens of countries with a total population of over 3 billion people.”

If that doesn’t unseat the dollar, what will? (Pardon the digression.)

The bottom line is that bottom line is skinnier than most people are assuming. We’re talking $1 to $1.5 trillion which covers only five to seven percent of China’s $21 trillion money supply.

Exacerbating matters is the fact that it is not purely speculators driving the yuan’s moves. Domestic depositors are moving their money out of the country for fear that the economic slowdown could morph into something far worse. It’s conceivable that outflows could deplete the reserve cushion by the time we’re ringing in the next new year.

That leaves China’s leadership with three options according to Wray’s wisdom:

  1. Attempt to strengthen China’s capital controls to stop the bloodletting of outflows and thereby stabilize the yuan.
  2. China can burn through their reserves trying to buy time. But this ends in tears as they are forced to float the currency from a position of weakness.
  3. OR, China can preserve its reserve stash and float the currency in the next few months from a position of relative strength

“Yes, there’s a lot of risk involved with free floating the aspiring reserve currency earlier than planned, but waiting around for a major yuan buyer to suddenly emerge is downright reckless,” Wray warns.

Gabe Kaplan, who played the Sweathogs’ Mr. Kotter once cited The Marx Brothers as inspiration for the sitcom’s plot lines and character behaviors. Classic slapstick made the show’s first few seasons magical. But the show died an early death as casting challenges set in and stardom beckoned a young Travolta to light up a disco dance floor in Saturday Night Fever.

Will China’s financial miracle meet its own demise thanks to what appear to be increasingly uncontrolled Sweathog-like shenanigans? Or will they graduate to a rational, well-run economic superpower thanks to taking the higher Silk Road home? For the time being, we will all have to put our seatbelts on and be satisfied with staying tuned until their next season’s episodes air.