“I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said,” 'Easy' Al Greenspan once told a Congressional committee during his helm at the Federal Reserve. For seventeen long years, analysts and traders alike were often unable to correctly interpret Greenspan’s double speak. But since early March, 'Guru' Greenspan has been very clear on at least three occasions that the US economy faces a 1 in 3 chance of a recession in the second half of 2007. If correct, there is also a 2 in 3 chance that the world’s largest economy would continue to grow, albeit at a slower pace than 2006. For the record, the Dow Jones Industrials are up 12% since Greenspan’s first warning of a possible US recession back on March 6th, operating on a different set of fundamentals.
Guru Greenspan is now predicting that the world’s second biggest bubble, the Shanghai Red-chip stock market is about to deflate in a very big way. “It is clearly unsustainable. There’s going to be a dramatic contraction at some point,” adding that a market correction could also cause problems for Chinese personal wealth. The Shanghai Red-chip market soared 130% in the past year, hitting an all-time high of 4,205 on May 24th, and is up 56% so far in 2007. And who knows more about hyper-inflating markets than the world’s greatest serial bubble blower? – Greenspan himself. It’s easy to argue that “what goes up, must come down” and the parabolic rise of the Shanghai red-chip market certainly gives many traders outside of the Chinese crowd a severe case of acrophobia (fear of heights). But stock markets don’t necessarily follow the laws of Newtonian Physics. Instead, markets can defy the laws of gravity if the central bank prints enough money to keep prices afloat. In Russia for instance, the M2 money supply is up 54% from a year ago, buoying the Russian Trading System index in the stratosphere. So far this year, the People’s Bank of China (PBoC) has only taken baby steps to restrain the Shanghai red-chip market, sort of like fighting pneumonia with aspirin. Bank reserve requirement ratios have been raised to 11.5%, and savings deposit rates lifted to 3.06 percent. China has now raised interest rates four times since April 27, 2006, and reserve requirements eight times since June 2006. But China’s biggest banks are still holding 2% of their reserves in idle cash, so the latest move by the PBOC in hiking reserve ratios to 11.5%, won’t have much impact on slowing down lending nor the rapid 17% growth rate of the M2 money supply. With China’s consumer price index humming at a 3% annualized rate, the savings deposit rate of 3.06%, barely compensates investors for inflation.
However, for the first time in two years, China’s 5-year bond yield has begun to move higher, climbing to 3.50% today, from 2.60% in late January. The PBoC has also been selling bills and notes to soak up cash flowing into the country from China’s trade surplus, which swelled to $177 billion last year. Still, Chinese bond yields haven’t climbed high enough to derail the powerful stock market rally. It remains an open question whether Shanghai red-chips are in bubble territory as Mr. Greenspan believes, since company profits averaged a 100% increase from a year ago, lowering the market’s P/E ratio from 42 in Q’4 towards 23 in Q’1. Furthermore, Beijing is careful not to rattle Shanghai with dramatic tightening moves, and is reluctant to use the most powerful weapon in its arsenal, - a stronger yuan. Allowing the yuan to strengthen by 10% to stave off US protectionist legislation against Chinese exports into the US, could lead to the loss of 5 million Chinese jobs, according to the PBoC. Furthermore, a 10% appreciation of the yuan would lessen the need for PBoC to print massive amounts of the currency to keep it artificially low. Since the Shanghai stock market is liquidity driven, less yuan printing by the PBoC could lead to higher bond yields and a flat to weaker stock market. That’s something Beijing wants to avoid, and is willing to risk a trade war in a game of chicken with the US Congress. Beijing’s best friend is US Treasury chief and former Goldman Sachs CEO Henry Paulson, who is willing to sacrifice US factory jobs for Chinese capital. To reward Paulson and Wall Street for their support of China ’s trade policies, Beijing agreed on May 23rd, to lift a freeze on foreign firms entering its securities industry, and will allow approved international investors to purchase up to $30 billion of stocks usually reserved for domestic buyers, compared with the $10 billion quota before. A Chinese business delegation on tour in the US also signed $32.6 billion in other commercial deals in a late bid to soothe US Congressional anger at Beijing. But Senators Charles Schumer, a New York Democrat, Lindsey Graham, a South Carolina Republican, Max Baucus, a Montana Democrat, and Charles Grassley, an Iowa Republican, said they would move ahead with proposals to slap tariffs on Chinese imports anyway, because Beijing won’t allow for a significant revaluation of the yuan against the dollar to rectify the $233 billion trade imbalance between the economic giants, and they plan to introduce the legislation in June.
Setting the stage for a confrontation, China’s central bank chief Zhou Xiaochuan said on May 23rd that he will stick to plans to lift the yuan gradually, and disagrees with the faster pace demanded by the US Congress. “Right now, the speed of reforming the exchange-rate regime and flexibility goes quite well, and in a good speed. They may think that we can accelerate the speed of reform, but we think that we already try our best, and domestically we have pressure to slow down,” Zhou said. Zhou was backed up by deputy PBoC chief Su Ning, “Though the exchange-rate policy as a price leverage could promote the trade balance, it can only serve as an auxiliary policy tool. It is not reasonable to set a linkage between the trade problem and the exchange rate,” he explained the same day. “We’re moving forward,” replied House Ways and Means Committee Chairman Charles Rangel on May 23rd. “I had to make it abundantly clear that we speak on behalf of the people of the United States and we give limited power to the executive branch to negotiate trade on our behalf. The responses from China are always the same and that is that they’re trying to bring reform and it takes more time,” Rangel said. Of course, the big problem for Beijing is its huge portfolio of US bonds, which has already depreciated around 12.7% against the yuan over the past three years. Although the exact composition of China’s $1.2 trillion of foreign currency reserves is unknown to outsiders, it is generally estimated to be around 70% in US dollars, or $800 billion in US bonds. By allowing the dollar to fall by 10% against the yuan, Beijing would suffer a minimum loss of $80 billion to its FX portfolio.
Yet on the flip side, the recycling of China ’s trade surplus and Arab oil kingdom’s petrodollars into US Treasuries have kept long-term US yields artificially low by up to 100 basis points, thus cushioning the slide of US home prices this year. For the past eleven months, the US yield curve has been inverted despite elevated inflation pressures in the US economy due to the insatiable buying habits of Asian central banks and Arab oil kingdoms, who covet US military protection in the Persian Gulf. Over the six months to March, China steadily raised its holdings of Treasuries by $28 billion to $420 billion, helping to keep the US 10-year yield in a tight range between 4.50% and 4.90 percent. But the latest up-tick in the 10-year T-note’s yield to three-month highs might be also linked to speculative ideas of an the exodus of foreign central banks out of US Treasuries, if Congress slaps tariffs on Chinese exports. In the game of high stakes poker, Beijing is standing pat, betting that Congress folds. But Congress has done its homework. On Feb 14th, Federal Reserve chief Ben Bernanke was asked if China were to use its huge US Treasury holdings as a weapon against the United States. “I think the cost to them of doing this would be greater than the cost to us,” Bernanke told the Senate Banking Committee. “I think a substantial move on their part would be disruptive in the market in the short term. But in the longer term the dollar, the Treasury yields would largely recover,” he said. Bernanke noted China’s holding of US debt was less than 5% of the total, “and even if such a shift were to put undesired upward pressure on US interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our economic goals,” Bernanke said on March 26th. Thus, Bernanke indicated a willingness to step up Fed purchases of US Treasury bonds should Beijing decide to shoot itself in the foot, and start dumping Treasuries. Still, the PBoC’s $3 billion stake in US private equity firm Blackstone Group this week, is a clear signal that Beijing is shifting into riskier assets in search of higher returns, and that its future purchases of US bonds may diminish. If correct, Beijing could exert upward pressure on US mortgage rates, undermining home prices.
Since mid-March, the Dow Jones Industrials (DJI) and the US Treasury Note market have started dangerous divergences, with the DJI climbing north, and T-notes sliding south. The second leg of the T-note slide began on May 10th, shortly after House Trade Subcommittee Chairman Sander Levin, a Michigan Democrat, vowed to pass legislation aimed at protecting American jobs by pressuring China and Japan to raise the value of their currencies. AFL-CIO labor federation's policy director, Thea Lee, urged Congress to pass legislation crafted by Rep. Tim Ryan, an Ohio Democrat, and Rep. Duncan Hunter, a California Republican, to slap tariffs on goods from countries that manipulate their currency for a trade advantage. General Motors’ chief economist, Mustafa Mohatarem, said Congress should lead an international effort to pressure Japan to raise the value of the yen. Levin told reporters that Congress could start action on such legislation in coming weeks. The heavy inflow of Chinese retail funds, strong corporate profits, and double-digit economic growth combined to drive up the market value of the Shanghai and Shenzen stock exchanges to a record 17.43 trillion yuan (US$2.23 trillion). And for the first time in history, their market value surpassed the country’s savings deposits of 17.37 trillion yuan, thus making the stock market a major aspect of China’s wealth and a key psychological driver over other Asian stock markets. If the US Congress does slap China with import tariffs, it could be the smoking gun that Guru Greenspan is looking for, triggering a shakeout in Shanghai that rattles Asian and global stock markets. On May 24th, US Senator Graham urged Beijing to significantly revalue the yuan to avoid major damage to US-China relations. And who knows what type of volatility lies ahead. On May 21st, the Bank of Int’l Settlements said the face value of over-the-counter derivative contracts for global bonds, currencies, commodities and stocks, rose 39.5% to a record $415 trillion in 2006, the biggest annual jump in history. Undoubtedly, leveraged positions have mushroomed since then. Gary Dorsch © 2007 Gary Dorsch
|
