In 3 Idiots, one of my favorite (Bollywood) movies which is about the power of free thinking and true friendship to break lifelong dogmas and elevate lives out of an oppressive rat race, a central mantra is “ALL IS WELL!”. This forms the philosophical basis for the protagonists shutting out challenging reality and its diminishing emotional impact in order to launch themselves out of numerous, and sometimes hilariously sticky situations. This week, our own Federal Reserve has done a very uncharacteristic thing and signaled the opposite when they decided not to raise short-term interest rates off the zero level because of “recent global economic and financial developments“.
In my last post “The Dow is back at 2013 levels … now what?” in August, I opined that the Chinese (competitive currency devaluation) wildcard would change the fundamental nature of the economic pseudo-stability we have gotten used to in the last many years of well-coordinated Quantitative-easing between the US, Japanese, and European Central Banks as they have re-inflated their respective economies (and equity markets) out of the depths of the Great Recession of 2008/2009. This QE has resulted in the unintended consequence of an emerging market slowdown starting with commodity exporting countries like Brazil and Russia, and is now affecting export-oriented China (now the 2nd largest economy in the world) whose currency has (until recently) been pegged to the US Dollar. Since the time of that post, we have seen some strong indications about the mechanism of China’s response and some likely economic outcomes if such a response continues.
- Marketwatch reported this week that China’s US Treasury Bond holdings dropped $30B in August with an additional $55B sale out of associated dealers in Belgium. We believe that selling these US Treasury holdings was the primary mechanism used by China to devalue the Renminbi against the US Dollar and the Euro. For reference, the Fed was purchasing $85B a month in long-dated Treasury Bonds at the peak of past periods of Quantitative Easing, so it is interesting that this salvo totaled about that amount.
- We believe that despite official rhetoric of this being a one-time move, China has no option but to continue down the path to competitive devaluation relative to its primary export markets in order to stimulate growth. This is not only due to the extent of instability in the Chinese financial markets (Chinese “A” shares trading on the Shanghai Stock exchanged dropped almost 20% the night (US time) before the Fed announcement on Thursday while the US equity market was enjoying a 600 point rally). More importantly, continuing devaluation of the Renminbi is required to address the root cause of this instability, which is the Chinese growth and export slowdown, and the resulting exit of capital from the China’s financial market and Emerging Markets in general.
- It is not clear if the Fed actually intervened in the Bond Markets by absorbing the supply with fiat Dollars at the time of the Chinese sale, but the fact that the US Dollar actually dropped during the period of and shortly following the Renminbi devaluation indicated that is what may have happened, since we should normally have seen a rise in the US Dollar from such a sale.
- We believe the Fed has started to actively stabilize and even reflate the US equity markets. This same 600 point rise in the Dow leading up to the Fed announcement at a time of low trading volume, carries a signature pattern which we identified in 2011 as the manner in which QE injected liquidity enters the US equity market (see “Signature of the Stimulus”). This is one of the macro reasons we think there is a floor of around 15,000 for the Dow for the current round of equity market volatility, in addition to there being strong technical support at that level based on our fractal inter-market models.
Putting all this together, a realistic scenario that emerges is of the Chinese continuing to competitively devalue the Renminbi against the US Dollar and Euro, the Fed intervening through an absorption of this Treasury demand in a manner similar to QE, the Dollar reversing its up-trend and starting to weaken in consequence, and global growth continuing to flounder until the Chinese export engine resumes and the demand for commodities and Emerging market exports starts to increase again. How much demand can this cheaper supply of goods stimulate in this new world of suppressed aggregate demand is anyone’s guess. Our view is that this increase would be measurable, but not sustainable, since it would be accompanied by inflationary forces.
I am glad that the Fed is signaling “ALL IS (NOT) WELL” by recognizing the very real risks posed by this emerging market slowdown. They will need to intervene a lot more than to simply not raise short-term interest rates to prevent this risk from getting contagious (bellwether US Treasury Bond and US Equity markets could crash and hence start to affect the US economy, which is one of the few relatively healthy demand growth engines left remaining in the world).
But there is no free lunch, and such intervention, if pursued, will have future unintended consequences. Connect with me on Linked-in to get our viewpoint on this story as it unfolds.