Chinese Growth Slows, Hurting Regional Trade Partners

Our last update on the Chinese economy expressed concerns over the future path of growth. The transition to the free market from a centrally-planned state has proven to be difficult as the government fights financial and political corruption, a growing middle class, and international pressure to liberalize its currency, the Yuan.

Chinese growth is slowing, but there’s nothing that the once frequently interventionist government is going to do about it. In part, growth slowed alongside lending activity, as the People’s Bank of China has maintained tighter monetary conditions for two main reasons: as it attempts to weed out illegal and corrupt banking practices that take place off companies’ balance sheets, “shadow banking.”

If only to consider the scope of this problem, on June, the interbank lending rate, overnight SHIBOR (local equivalent to LIBOR), rose by an astounding 578-basis points to 13.4%. In comparison, the 1-week SHIBOR rate rose by 292-bps to 11.0%; this inversion of the SHIBOR curve is a strong indication of extremely tight credit conditions. Typically, yield curves invert when liquidity is a problem; the fall of 2008 was plagued by this issue in the United States in particular.

In our last post regarding Chinese growth, we said, in a ‘tongue-in-cheek’ manner, that “There’s one major caveat to Chinese data that is truly inapplicable to any other global economic force: you just don’t know if you can trust it. Chinese data seemingly comes out of a black box, where Chinese government readings of the economy tend to outpace private sector readings, or even eclipse foreign government estimates of economic activity.”

Were those views ever vindicated: in June, the Chinese government said that so-called arbitrage transactions distorted trade figures in a manner favorable to stronger growth. From Bloomberg: “The transactions “resulted in abnormal growth in mainland-Hong Kong trade for a few months” since the fourth quarter, Shen Danyang, a Commerce Ministry spokesman, said at a monthly briefing today in Beijing. “Even if these arbitrage trades are not necessarily illegal, they are not fully compliant with regulations. That’s why the government has been concerned about this.”

As the government faces these issues and more on the way to opening up the Chinese economy even further, it’s evident that any new policies will be geared towards a more regulated, transparent economy. Accordingly, to prevent fueling a housing bubble (which is a concern now), the government is unlikely to implement further fiscal stimulus in the near-term. This has and will leave the economy weak in 2013:

China GDP

As long as Chinese growth remains in a rut, global trade will remain dampened and hopes for broader global recovery will be teeter. An ongoing concern for Australian policymakers, signs of slowing Chinese growth continue to weigh on the economy, where the Reserve Bank of Australia cut the main rate to a record low 2.50% in August.

The reasons behind the Reserve Bank of Australia’s rate cut are critically important, and are why we believe that, thanks to China, the Australian Dollar could remain under pressure in the interim.

European Growth Rebounds and Bolsters Euro Turnaround

This post will discuss the improving economic conditions that have started to emerge from the Euro-Zone. Policymakers have a difficult task of balancing a diverse regional economy marked by declining rates of production, consumption, inflation, and overall growth, all of which are exacerbated by a recently-strong Euro.

The Euro-Zone has backed away from the brink of collapse – for now. The recession that’s gripped the region since the 2Q’12 appears to be abating, with the contraction appeared to having bottomed in the first half of 2013.

Euro 10 yr bond spreads

The rebound, in its entirety, can be attributed to the European Central Bank’s efforts to reduce financial risk in the region in the summer of 2012, when it announced its outright monetary transactions (OMT) program, essentially an unlimited safety net for Euro-Zone countries facing high borrowing costs in trading markets.

Euro GDP

The Euro, with the tail-risk premium of a break up very-much diminished, has sparkled amid the turn in growth prospects. After bottoming just above $1.2000 against the US Dollar in July 2012, the Euro has spent much of 2013 trading above $1.3000, trading as high as $1.3832 on October 25. The resiliency of the Euro is commendable two-fold: first, not only due to warding off breakup threats; but also because the US yields have risen sharply thanks to the Fed’s upcoming reduction in QE3.

Euro PMI

The rebound in regional economic activity, of course underpinned by stability in peripheral bond markets, may continue through the remainder of 2013 and into early-2014, if incoming PMI data is accurate. In fact, the last time we discussed the Euro-Zone crisis, manufacturing and services PMI figures from across the region were struggling below 50, the demarcation between growth and contraction.

In February 2012, only German PMI Services showed growth, while the other seven gauges tracked (manufacturing and services for Germany, the Euro-Zone, France, and Italy, each) were contracting. Indeed, our last commentary was near the “bottom”; and now five of the eight PMI readings are in growth territory (see chart above). Further sustained signs of economic progress in the region will only further serve as a bullish catalyst for the Euro.

Going forward, political risk is what could undermine the Euro. Corruption in Spain and Italy threatens the governments (the latter especially), while record or near-record high unemployment rates across the Euro-Zone will only serve as a constant reminder as to how far the region needs to go before “recovery” can be declared. Depending on what the Fed does over the 4Q’13 – will it taper? by how much? in what increments? – the EURUSD is positioned for the time being to finish the year above $1.3300 so long as political pressures remain subdued and further signs of European ‘green shoots’ emerge.

Rate Differentials and Expected Policy Action by the RBNZ Keep the Kiwi Looking Up

Reserve Bank of New Zealand Governor Graeme Wheeler currently faces a problem. On one hand, exporters are losing their competitive edge as the New Zealand Dollar has strengthened. Industrialists have called for the RBNZ to try to keep rates pointed lower in order to weaken the currency. Certainly, ever since the Federal Reserve suggested that it might begin to normalize policy, New Zealand government bond yields have increased.

Given the implications of the Fed removing liquidity from global markets, bond markets have been under pressure. Considering that investors had piled into those assets with any yield over the past few years, these same assets – including New Zealand government bonds – have seen their yields spike higher faster than their policymakers can deal with (as seen in emerging markets).

Bond spread_NZDUSD

Over the past several months, the results of the Fed’s taper speculation have provoked the NZ-US 10Y yield to widen to their largest differentials all year. This will be important for future Kiwi strength: widening interest rate differentials are supportive of a stronger currency. The recent divergence could be due to the broader repricing of risk assets to compensate for a slower easing Fed. But domestic New Zealand data is pushing rates up higher naturally.

Rate increases_NZDUSD

Over the past three months, RBNZ Governor Wheeler has used his press conferences not to make a concerted attempt to weaken his currency but rather to highlight the optimistic points on the economy. In fact, currency swaps traders are near their most bullish on the New Zealand Dollar all year, with respect to the number of basis points priced in. If this pricing mechanism exceeds 90-bps, it will be closing in on its most bullish reading since the New Zealand Dollar peaked in the summer of 2011.

Why is this information useful for hedging? If the swaps market is pricing in future rate hikes by a central bank, it might be an appropriate time to hedge against further upside risk in the currency.