Dec 08/15 – It won’t be different this time

2015-12-08 11am EDT  |  #China #commodities #FX #PBOC #US dollar

The commodity carnage continued yesterday with the Bloomberg commodity index falling to levels last seen in 1999.

The decline has been relentless. Iron ore, oil, copper, even grains, they are all being taken out to the wood shed and shot.

By now everyone knows the bear story, there is nothing to add trying to understand how we got here. And in terms of predicting where we go from here, it is much more of a crap shoot than either the bulls or the bears believe.

We have hit the capitulation part of this move. Investors are puking out positions regardless of fundamentals. There is no sense trying to understand market movements – they are simply reflections of the weakest held positions.

I can’t remember the exact trader lore, but it’s something like the last 5–10% of the move in terms of time, has 50% of the price movement. As we approach the crescendo, the trend becomes even more powerful, to the point where it gets dramatically overdone.

Right now there is no doubt the down trend is becoming more powerful. The commodity bears are becoming emboldened, and the bulls are desperately fleeing the ship trying to save themselves.

The fact the Fed is about to hike rates for the first time in almost a decade is only making things worse. We all know it is coming, so there is zero reason to step ahead of the commodity liquidation. As the buyers disappear, the bears become more convinced they are right, and they push their short bets even harder.

Any sort of bullish argument seems foolish and ill advised. Blue tickets are almost instantly offside, and it is tough to argue with the P&L.

But like all moves throughout history, we will eventually bottom. And just remember, we will do so with the bears feeling invincible and precious few bulls. It will only be hindsight that it will seem obvious it was overdone.

I don’t know where that point will be in terms of price, but I am betting we are much closer in terms of time than participants realize.

Next Wednesday we will get the Fed’s rate hike. Higher rates are getting fully baked in, and some investors are realizing there is a potential for the US dollar to top into the announcement.

However, many investors are thinking past this move and speculating that higher US dollar rates will force China to devalue. This line of thinking is exemplified by Passport Capital’s John Burbank’s recent comments at the Ira Sohn conference. John was pitching the idea of owning CF Industries, which is a fertilizer company. But he is bearish on commodities and most importantly;

Burbank thinks that China will devalue. “If China devalues everything in the World will go down in value.” CF’s earnings will get hit too by about 7%. Passport has bought CF against a basket of commodity shorts.

“If China devalues, everything in the world will go down in value” is the typical line of thinking amongst investors.

Although I understand the logic about the deflationary wave unleashed with a lower Yuan, here is something else to consider…

Sometimes markets don’t do what everyone expects…

With the Yuan’s soft peg to the US dollar, over the past few years, the Chinese currency has become one of the strongest currencies.

This currency strength has slowed down the Chinese economy, and created a situation where instead of the Yuan being pegged too low, it is now pegged too high. Capital is fleeing China. Instead of being required to sell Yuan to defend the peg, the PBoC is now forced to buy Yuan.

These persistent outflows are causing China’s FX reserves to decline.

This outflow needs to be stopped. It is obvious to everyone the Yuan is too strong, and until it gets lowered, capital will flee China.

For the past few quarters while they were applying for IMF SDR membership, the Chinese were reluctant to mess too much with their currency. But that obstacle is now behind us.

Investors realize a Chinese Yuan devaluation is coming, the only question is timing and its effects.

Gun to my head, I think China devalues ahead of the Fed’s first rate hike. That way if things go bad, they can blame it on the Americans for raising rates. At least that is what I would do. So watch for a potential devaluation this weekend.

Regardless of timing, it is coming. The important question is how it will affect the markets. Smart shrewd guys like Passport’s John Burbank believe it will be extremely negative for commodity prices. They think it will unleash a deflationary wave.

That could be, and who I am to argue with accomplished guys like John? But a little part of me wonders if they are misreading this situation.

With the Yuan being pegged too high, the Chinese government is being forced to sell US dollars and buy Yuan. They are therefore selling US dollar assets.

Have a look at this great chart by Bespoke Investments that outlines the selling of US Treasuries by China (through their Belgium holdings):

There is obviously much more that influences bond rates than the action of one foreign Central Bank, but a the margin, there can be no doubt the Chinese selling is causing rates to rise in the US.

And herein lies the problem. Real rates in the US have been rising, and this is slowing the global economy. Have a look at the chart of the US 10 year Real Rate (the US 10 year bond minus the CPI rate):

What if this increase in real rates could be slowed (or even reversed) with the end of Chinese selling?

If China were to devalue by large enough amount, money would stop fleeing, and in fact might go the other way.

Don’t forget the initial symbiotic relationship that got us into this mess in the first place. US buys Chinese goods because their currency was too cheap. PBoC sells Yuan buys US dollars to facilitate the transaction. PBoC buys US Treasuries and in the process drives down interest rates, thus encouraging US to borrow more and repeat the circle of debt.

It should be no surprise that as this trade unwinds because of a Yuan pegged too high, that rates rise. The only question is how much pain the officials endure before returning to the well.

My guess is we are extremely close to China pulling the rip cord on a devaluation. Who knows, they might even just let the Yuan float. At which point it might skid even lower than it should be, but at least the Chinese can claim they are adhering to market principles. The only thing nagging at my craw is that I am not sure they will want to take this risk right before year end.

Regardless of timing, hedge funds are all set up for this event to be negative for commodities and usher in the next wave of deflation. I am willing to entertain the idea that a Chinese devaluation might surprise investors with a return to the previous era of lower interest rates, and maybe even higher commodities.

Either way be careful being too bearish down here. Volatility will rise, there is no doubt about that. And as commodities sink even lower remember that the best cure for low commodity prices is low commodity prices… It wasn’t different five years ago at the top when hedge funds were convinced China would buy every commodity on offer forever. It won’t be different this time at the bottom when they are equally convinced commodities are worthless pieces of trash.

Thanks for reading,

Kevin Muir

the MacroTourist