Rockjaw’s TWIST – Chinese riddle??

rockjaw twist a

As a guest contributor to RKTP Capital Management blog, Rockjaw provides a “Twist” on the markets:

The dollar is higher against the majors but down a bit against the CAD and AUD, possibly on recoveries in oil and some metals. Sentiment seems fairly pro-risk but a bit schizo since equity markets in Asia tanked but European bourses and US equity index futures are higher. We have a ton of data and fresh news this week.

It will be easy to get distracted.

The 10-year Treasury yield hit a new high of 2.74% late Friday, closing down around 2.72% and quoted at 2.71% this morning (FT), although we also see 2.69%.

Fear of a Chinese hard landing is returning but not at panic levels yet.

Peripheral European sovereign debt worries are shrugged off on some improvement in conditions in Greece and Portugal.

The Fed remains in the spotlight, with the minutes of the June meeting due for release on Wednesday, when Bernanke speaks in Boston about policy, but will not be attending the Jackson Hole shindig that starts on Friday.

The euro is recovering correctively this morning to 1.2960 so far around 7:30 am ET after hitting the ropes on Friday on US payrolls, a low of 1.2803, nearly to the lowest low from May 17 at 1.2793. Those old lows have some real juice sometimes. We had to expect a pullback after such a big drop. We get linear regression resistance at 1.2950.

Notice that position adjustments seems to have outweighed the hard news, which otherwise would seem to be euro-negative. First, over the weekend, ECB VP Noyer tried to downplay Draghi’s “forward guidance.” The mandate remains the same, he said, referring to inflation.

The other euro-negative, if probably an aberration, is German industrial production missing the mark in May at a drop of 1% when -0.5% was forecast, although April was revised from 1.8% to 2%. The source of May weakness was construction and capital goods. In addition, May German exports fell 2.4% after negative 1.4% in April for the sharpest decline since 2009 and more than expected. To be fair, imports rose 1.7% after +1.2% in April, and imports denote growth. Still, the trade surplus fell almost 20% to €14.1 billion. We don’t have a breakout showing how much of that is due to China.

The dollar/yen is wobbling around near 101.25 as everyone waits for New York to make the next move, after a stunning one-hour gain on payrolls on Friday (100.00 to 101.14). The overnight high was 101.55. Data supports the idea of Japanese recovery—bank lending is up, the current account is more favorable—but everyone awaits the BoJ policy meeting this week.

The MoF reported that Japanese investors are unloading foreign assets at a torrid pace, including a record ¥3 trillion in US Treasuries in May. It’s the 5th month of net sales and the largest since 2005. Also, according to Bloomberg, “In June, Japanese investors were net sellers of overseas debt valued at a record 2.96 trillion yen, taking the total to 10.6 trillion yen this year, the data show. That’s on track for the first net annual sales ever.”

In addition, Japanese investors fled the AUD, ¥133 billion in governments in May for the 10th month of net sales and another ¥313 billion of Australian dollar-denominated debt. And they switched into euro (huh?): “Euro-based bond buying was the largest among the 10 currencies tracked at 1 trillion yen, with net purchases of German sovereign securities worth 1.2 trillion yen.” Well, Abe wants to rebuild the domestic monetary base.

This morning the FT bond spread table shows peripheral yields are steady. The yield on 10-year French notes is 2.28% from 2.27% (but 1.95% on 05/24). The yield for Italy is 4.38% from 4.37% (and 4.55% last Wednesday). Spain has 4.63%, the same as Friday morning. The record high last July was 7.69%. Portugal has 7.05% from 7.00% and 7.88% last Wednesday. Greece has 11.05% from 11.61% on Friday.

European Sovereign Debt Crisis: Portuguese PM Coelho reorganized his cabinet over the weekend, not only replacing the two ministers who resigned last week but appointing new ministers from other parties, considered a valuable conciliatory gesture. Foreign minister Portas, who resigned last week, was elevated to Deputy PM. Coelho needs him because he leads the conservative coalition party. Portas will deal with international creditors, among other functions. And not a minute too soon—talks with the troika begin July 15. Also from the conservatives is the new economics minister Pires de Lima, which somewhat offsets Coelho’s choice for the new finance minister, who is considered pinko.

Always a day late and a dollar short, S&P downgraded Portugal’s outlook from stable to negative on the grounds of political uncertainty that could derail the planned bailout exit in 2014. But Coelho says the country will exit on schedule and with no drama. This latest move gives the impression he’s a capable guy.

The Greek situation is worse. The FT says Greece “broke a deadlock” but if you read the details, conditions are still iffy. The troika has completed a report on the mandated reform progress that goes to the eurozone finance ministers later today, according to the WSJ, to “approve at least a partial disbursement of aid to Athens.” The IMF makes a separate decision later this month in the context of Lagarde having admitted the IMF lied and broke its own rules about the prospects for bailout success. Evidently Greece has been lagging on cutting public sector jobs (remember the state broadcast brouhouha) but now promises it by year-end. Two things—the report says the outlook for Greek recovery is “uncertain.” And the troika report has still to be approved by the Greek parliament. The probability is getting higher by the minute that Greece will need a bigger, longer-lasting bailout.

On the equity markets the Dow rose 0.98% and the S&P, 1.02%. Market guru Lynne notes that earnings season kicks off with Alcoa today after the bell, but the interesting ones will be JP Morgan and Wells Fargo on Friday. She also points out that rates surged last week but the stock market rallied anyway, evidently celebrating better growth. But growth is not really much above stall speed and “Sooner or later, higher rates will be seen as a detriment to growth.”

In Japan, the Nikkei fell 1.40% and the Hang Seng, 1.31%. The Shanghai fell 2.44%, ouch. In Europe, though, all the bourses are up so far today. At 11:02 am London time, the FTSE 100 is up 1.07%, the DAX, 2.16%, and the CAC, 1.75%. The Milan is up 1.32% and the Madrid, 1.48%.

The WTI oil futures contract closed at $103.22 from $101.24, one of the many times the purported inverse correlation with the dollar failed. At 6:50 am ET, oil is quoted at $103.63. Bloomberg reports that payrolls/growth and political turmoil in Egypt are key drivers, even though Egypt is neither a top producer or consumer and the Suez Canal is securely in the hands of the US military puppets now running the country. If we are going to have oil responding to events in Egypt, it’s going to be a lousy summer. Other factors include a railroad accident in Quebec that raises the whole issue of safety in transporting oil (think Keystone pipeline).

Gold and silver are also down today. Today was the first day of trading gold futures on the Shanghai exchange and volume was brisk. On the whole, the bears are winning out over gold bulls so far this year, although Bloomberg notes that history is on the side of a second half recovery.
Between 1981 and 2000, first half losses averages 3.9% and second half gains averaged 1.3%.

We have extraordinary conditions and looking backward at conditions two decades ago is not useful or relevant. In a nutshell, when real returns are moving upward from negative or zero to a positive number, money will flow to the higher real return. Gold is perceived to be expensive to hold with no inherent return unless it’s on a confirmed uptrend. There will always be someone who trashes the inflation-hedge and store of value fairy, story even when there is 400-500% growth for the decade. Restocking slowly at these prices gives longer term protection and capitalises any paper we might be dumb enough or forced enough to hold.

China’s largest private shipbuilder appealed for government aid on Friday, and today Bloomberg reports that the Shanghai “fell the most in two weeks as indexes tracking energy, materials and industrial companies sank to the lowest levels since November 2008.” Confidence in the economy is falling, not helped by the government engineering a credit crunch to make a point.

The UBS chief economist in China says “Despite recent signs of bottoming out in domestic activity, growth outlook remains fragile.”

A logical question is why the renminbi is still rising (up 1.7% YTD and 3.6% y/y, according to the FT). At what point do foreign investors get spooked?

FT columnist Davies writes that while it’s not quite a Lehman moment, the situation in China is at screaming emergency status. The giant stimulus after the 2008 meltdown is not being reined in properly and has resulted in a “classic credit bubble. The ratio of total credit to GDP has risen from around 115 per cent in 2008 to an estimated 173 per cent, an acceleration in credit expansion that has spelt danger in many other economies. Much of this has come in the poorly regulated shadow banking sector, where the annual rate of credit expansion currently exceeds 50 per cent.

The Chinese authorities are signaling, correctly, that this must slow sharply.” A credit explosion inflates the debt service ratio to something like 39% of GDP, when 20-25% is already enough to warn of a banking crisis, according to the BIS. Davies says “In order to soft land, credit growth will need to be reduced to single-digits for many years, compared to the 23 per cent annual increases seen since 2008.”

And overinvestment went to unproductive and sub-optimal sectors, too. There is an unholy mess to clean up here. Anyone who thinks the Australian natural resource sector, dependent on China, will quickly recover is delusional.

The Reuters 10-year yield index closed at 2.715% from 2.501% the day before on quite good payrolls, 195,000 jobs in June so that the average monthly rise since September is over 200,000, considered a benchmark threshold. The JP Morgan economist speaks for many when he says the taper will begin in Sept (and not December)

We have old themes with staying power and a few new themes that are still being tested. One of the enduring old themes is Greece failing to thrive and to meet troika requirements, so that additional bailout money is going to be needed. This was always going to happen and markets are not really willing to freak out about it, but just because something awful is anticipated doesn’t make it less awful. The euro is not being punished for Greece just yet but the possibility always exists.

Another old theme is what, exactly, the BoJ is going to do to further the aims of Abenomics. It holds a 2-day policy meeting starting Wednesday.

A third old theme is the Chinese slowdown. Nobody seems to have modeled the global effects, although we will get new IMF forecasts this week and they may not be pretty. Over the weekend, Lagarde said the forecasts will be lowered by an unspecified amount. The IMF structure divides the world into three speed-zones, starting with emerging markets, including China. That speed is currently 5.5% and may be the one cut back. The second zone is the US and a few others (Australia) at about 2%. The third is the eurozone, with zero growth. Averaging it out gets global growth at about 3.3%, but this is one of those cases where averaging is a stupid process that ignores dynamics. At a guess, a China/emerging market slowdown harms other emerging markets and the eurozone far more than the US.

As for new themes, top of the heap is Fed tapering. On Wednesday we get the minutes of the June 19 FOMC. One task will be to discover, if possible, who was puzzled by the rise in yields—Bernanke used that exact word in his press conference—and how much of the overreaction was anticipated. This is actually quite a contentious topic because it touches on basic competence. After all the talks and academic papers, you’d think Fed officials would know how much yield curve shifting to expect when tapering and ending QE was announced. How could they not have understood that tapering would be perceived as tightening, no matter how many denials they issued that tapering is not a “policy change”?

Does anyone suspect QE is simply to take another form?

Also new is the outlook for the EMU banking union, which seems to be frightful mess. EU financial services commissioner Barnier will present a proposal (Wednesday). for a single euro-area authority to handle failing banks.

Other US releases this week include consumer credit today, retail chain store sales and the usual Thursday jobless claims, PPI (Friday) and the Jackson Hole central bank shindig. In recent years Jackson Hole has been a top venue for the world’s central bankers and many of the papers are original and top-notch (like Mishkin’s on the effect of a housing bust just before it happened).

But this time Bernanke will not be attending for the first time in 25 years that the US central bank chairman has not attended. He named a scheduling conflict but the indefatigable press wonders if it’s a sign of disrespect or a sign of his pending retirement. As for disrespect, the host of the event, the Kansas City Fed, has long opined that QE was forming a bubble in agricultural land prices, among other drawbacks. The former Kansas City Fed Pres Hoenig (now at the FDIC) wrote some really good articles on QE and bubbles, including some that made it to the NYT and other popular venues. Did all this just sink under the waves with no ripple remaining?

This leads to the final point, and we say it’s the key point: Does the Fed know how much inflation is coming, and when? The Fed staff has more information and more models than anyone. How can they not have an estimate or two or three? It was Nixon a generation ago who said “We are all monetarists now” and the Fed is underrating the extent of inflation fear. Maybe it’s not visible in measures of inflation expectations (like the TIPS spread) but gee, don’t they read the papers? The fear is real, it’s widespread and deep, and it’s not silly or crackpot. Maybe it was crackpot when deflationary recession, aka the Japanese disease, was still a real possibility, at least in Mr. Bernanke’s mind. But if he is now comfortable that deflationary recession is off the table, the obvious question is the next path for inflation, and since the Fed took it upon itself to inflate the Fed balance sheet, it owes us an explanation of how it’s going to deflate the balance sheet.

Bernanke might say that we are missing the point—that it’s not the Fed’s balance sheet that causes inflation. True. But still, we want an estimate of upcoming inflation trajectories, with footnotes, if Bernanke is to retain an ounce of credibility with his darling financial media.

We like the dollar. It had growth and yield and not too much Washington craziness these days.

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