FXIS Market Insights

Weekly Snapshot
• Citigroup reports $3B profit on gain from sale of Smith Barney; analysts had forecast a loss (AP)
• Bank of America reports $2.42 billion profit (AP)
• Brazil increases its exports to China, currently Brazil's largest trading partner (Economy.com)
• US Housing starts in June stronger than expected at: 582,000 units (Bloomberg)
• JPMorgan Chase announced Q2 profits of $2.7 billion, 36% higher than a year ago (Economist)
• Euro area inflation in June -0.1% compared with '08; core inflation (excl. energy & food) was 1.2% (Eurointelligence)
• China’s foreign-exchange reserves rose a record $178 billion to $2.132 trillion, the world’s forex reserve (Bloomberg)
• China's government reported that growth accelerated to 7.9% in the second quarter (WSJ)
• The Shanghai stock market's benchmark index has gained 75% so far this year (WSJ)
• U.S. Consumer Price Index up 0.7% in June (Briefing.com)
• U.S. core CPI, which excludes food and energy, was up 0.2% in June (Briefing.com)
• Goldman Sachs reported a $3.3 billion profit for the last quarter (Marketplace)
• U.S. Retail sales in June came in a little stronger than expected at 0.6% (Bloomberg)
• U.S. core producer prices rose at a 2.1% annual rate, the fastest rate since the current recession (Economy.com)
• The overall PPI rose 1.8% in June, after increasing 0.2 percent in May (Bloomberg)

Chart of the Week
In our quest to look for signposts leading to a “new normal” in terms of the world economy, here is another example. Brazilian exports to China now outrank their exports to the U.S. by a considerable margin. This goes right along the lines of a previous announcement that Brazil & China plan to use their own currencies in trade rather than the US$.

Source: http://www.economy.com/dismal/


Recommended Read
Please consider reading: China’s Foreign-Exchange Reserves Surge, Exceeding $2 Trillion and China’s $2,000bn foreign reserves

If one had any doubts about China becoming a dominant economic power to reckon with, the sheer magnitude of their foreign exchange reserves in excess of $2 trillion should put these doubts to rest. As the Bloomberg article suggests, about 65% ($1.3 trillion) of China’s reserves are in US Dollar assets, a potential problem for both China and the U.S. In order to examine just a small part of the complex issues between the two dominant global trading partners and also to show the irony of the problems both countries are facing, let’s play a little what-if scenario; but first, let’s take a brief look at some recent history:

You may recall that the previous U.S. administration, in particular then Treasury Secretary Paulson, had frequently complained to China that their currency was kept artificially low and that it was about 40% undervalued. In case you ever wondered how the U.S. administration figured it was 40% overvalued, take a look at the chart below and know that as recent as the early 80’s, the Chinese currency traded closer to parity with the US$ (those were the official rates then and do not necessarily reflect purchasing power parity rates). Since then, China’s currency was allowed to loose value against the US$ through a series of devaluations and adjustments in the markets.

The ultimate economic turbo charger happened in January 1994. The Chinese government devalued their currency from 5.8145 to 8.7217, effectively a 50% devaluation of their currency in one day. This of course made Chinese products 50% cheaper overnight and may have been one of the dominant factors for the economic miracle we have experienced since. Talk about competitive advantage…


After some market adjustments, the Chinese Yuan then traded around CNY 8.3 to $1 for a good decade and at the height of “bilateral discussions” with intensified calls by the U.S. for an increase in the value of the Chinese currency, CNY was still trading above CNY 8 to $1, roughly 40% above the rate before the one day revaluation in 1994. Since then however, the Chinese government enacted a series of adjustments and CNY gradually increased in value against the US$ to a current rate of 6.8319 today.

Now what if...the Chinese government were to let it’s currency float or revalue all the way back to 5.8145?

For starters, Chinese goods would become more expensive. Although some Chinese manufacturers may somehow swallow part of the implied price increases, it is clear that Chinese exports would take a hit. Further, China’s US$ denominated reserves would now be reduced by nearly $200 billion. If China were to stop or even reduce their ongoing purchases of US treasuries the U.S. may face a problem financing its obligations and the Fed would have no choice but to raise rates. Raising interest rates, while making new U.S. Treasuries more attractive, could give the already suffering U.S. economy a blow it may not recover from for some time. It's clearly also in the best interest of China to keep U.S. consumers happy and able to continue purchasing their goods.

It is therefore hard to determine what the best options are for either side. It also calls into question any demand by U.S. officials who urge China to let its currency appreciate (a natural phenomenon for the country with the greater trade surplus). The U.S. cannot afford to anger its largest creditor but at the same time, China being a the largest lender to the US, it is in China’s best interest to keep the game going for as long as possible.

Think that a return to the value of CNY 5.8145 = $1 would be difficult to handle? What if CNY were to become a freely convertible and freely floating currency and would drift closer to the levels of the 1980’s? Can either of the two economic superpowers afford to let this happen? As the saying goes…

“If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.” - J. Paul Getty

Hence, any diversification out of the US$ must happen gradually and at this stage of the game, neither party can afford any drastic changes. On a final note, consider what would happen if for some reason, China were to devalue its currency again? It may be unlikely but it is conceivable. At least on paper, China's $1.3 trillion Dollar denominated assets would retain their relative value - but for how long?

Equity Markets - What a difference a week makes…
Last week, we looked at a technical chart, examined a "head and shoulders" pattern and concluded that if this technical trend reversal pattern were to hold true, the 800 level for S&P would be more likely than 1000. The head and shoulder turned out to be wrong as the pattern did not follow through. The S&P, along with most major stock markets, had a very strong week and closed Friday above 940. Already there are calls of an end to recession, but I would still rather err on the side of caution. Here’s why…

• Let’s not forget where we came from; we are still about 40% below the high of 2007.

• Although we have seen recent earnings surprises by some big companies, including some of the major financial institutions, we don’t see much if any growth in top line revenues. The cost cutting measures instituted by nearly every organization large or small can only go so far. Unless we see growth of sales, these “better than expected” earnings may not last. General Electric, who’s net profits fell 49% and revenues fell 17%, are probably a better indicator of a global economic climate, which despite some green shoots, is not out of the woods yet.

• Ongoing job losses, even if they were to slow down, will put a lid on consumer spending. Long-term unemployment rates in the US of close to 10% call for a jobless recovery at best. As a result, the US economy, which is largely consumer-driven, cannot produce the kind of growth and resulting company earnings that would justify a return to 2006/2007 levels.

• Some analysts still call for a bear market rally and that the S&P 500 rally was poised to end.


On the brighter side, a solution may present itself in the ingenuity and creativity of the small businesses and entrepreneurs that are still optimistic and will to put capital at risk, although with apparently much less economic (after-tax) incentives these days. Hence the best turn-around prospects for the U.S. are in its ability to devise new technologies and to increase productive capacity for selling U.S. products overseas. But an economy that has focused most of the past few decades on selling services and buying foreign goods may not easily be transformed into an economy with a substantial manufacturing capacity. It certainly won't happen overnight...

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Good luck & good trading!