Copper: A Diversifying Metal

Wednesday, June 23rd, 2010

This article is a guest contribution by Mark Noble of Horizons ETFs.

Copper: A diversifying metal

Copper can, and often does perform very differently from precious metals – gold in particular. According to data from Bloomberg, since December of 1988, the median ratio between gold bullion contracts and copper contracts has been about 3.35, meaning gold has tended to trade at 3.35 times the value of copper.

When prices move outside of this band, it may be an indicator that one of the metals is mis-priced relative to their historical relationship.

Gold’s use as an investment hedge and store of value means it’s trajectory of returns can be quite different from copper, which has a higher correlation to economic factors, most notably industrialization in emerging market economies, which require copper for basic manufacturing and development.

For this reason, copper has historically had a tendency to be correlated to other base metals. Its volatility can be quite high, especially compared to other metals, offering investment opportunities for adept investors over very short periods of time. The use of leverage in the Copper ETFs can magnify these potential returns.

The chart below from Bloomberg shows the nearly one year performance of the copper futures contract ending June 16, 2010 versus the S&P/TSX Global Base Metals Index. Notice the strong periods of deviation in the price of copper versus the index.

It’s important to remember that copper is a core product for many large cap metal companies, such as Xstrata and BHP Billiton. The leveraged inverse Copper ETF may be used as a hedge to protect copper producer positions.

A strong correlation to emerging markets

Copper has a unique relationship with emerging market economies, in particular China which, according to the 2009 World Copper Factbook, imports more than one quarter of the world’s copper (28%). Electronics manufacturing powerhouse Japan accounts for another 23% of copper importation. Other important emerging market economies, such as India and Brazil are also major importers of copper.

From a supply and demand perspective, the price of copper can be closely tied to the development activities of emerging market economies. Manufacturing increases or slowdowns in these economic regions can be leading indicators of the direction of copper prices or vice versa.

Based on historical data, over the past year ending June 16, 2010, the performance of the near-term copper futures index has had a beta correlation of 0.672 to the performance of the MSCI Emerging Markets Index Fund (EEM), the world’s largest emerging market ETF. The performance of copper over this period generally moved in the same direction as EEM performance, as indicated on the Bloomberg chart below.

Significant portions of the world’s copper supplies come from the South American markets of Peru and Chile. Political disruptions or natural disasters in these locations can have an impact on the short term supply of copper.

Regardless of your view on the direction of copper, two new copper futures-based ETFs from Horizons BetaPro Funds, HKU and HKD are different investment opportunities that offer exposure to the daily performance of copper futures.

You can get more information on these new ETFs at www.HorizonsETFs.com/Copper.

Tags: Accou, Base Metals, Basic Manufacturing, Bhp Billington, Bhp Billiton, Bloomberg, China, Copper Futures, Copper Producer, Core Product, Economic Factors, Emerging Market Economies, Emerging Markets, ETF, Futures Contract, Global Base, Gold, Gold Bullion, Index Notice, India, Japan Accounts, Metal Copper, Metals Index, Precious Metals Gold, Price Of Copper, Short Periods, Xstrata
Posted in Brazil, China, Gold, India, Markets | No Comments »

Hugh Hendry: “China is Looking Like 1920s Japan”

Thursday, May 20th, 2010

This article is a guest contribution by Courtney Comstock, The Business Insider.

Hedge fund manager Hugh Hendry, of Ecletica, says that right now, China looks a lot like Japan did in the 1920s.

“There are striking parallels with Japan in the 1920s, when ultimately the whole system collapsed,” Hendry told Bloomberg. “China could precipitate a much greater crisis elsewhere in the world.”

Japanese credit built inventory during and after World War I and then later, in the 1920s, Japan’s export boom collapsed amid excess global capacity. Japan’s growth was decimated and soon after, a stock-market crash and bank runs followed.

(China has also been compared to Japan in the 1980s.)

Hendry thinks China is now in the same boat.

“China’s at the mercy of a credit bubble,” he said. “Once you’ve unleashed the genie it’s out there. They are ultimately unstable and it’s that instability that creates their demise.”

So Hendry’s main fund, Eclectica Fund (global macro), used 1.5% of its asset value (the fund has ~$180 million in assets), $2.7 million to buy options on 20 companies in international markets that will profit from “a dramatic collapse” of China’s growth. If China’s economy collapses, the fund could make $500 million.

The wait until China’s bubble bursts could be less than a year or it may take three years, as Citigroup Inc. economists Willem Buiter and Shen Minggao estimate, Hendry said.

Tags: 1920s, Asset Value, Bloomberg, Bubble Bursts, Buiter, Business Insider, China, Citigroup, Citigroup Inc, Credit Bubble, Dramatic Collapse, Export Boom, Global Capacity, Global Macro, Hedge Fund Manager, Hugh Hendry, International Markets, Precipitate, Stock Market Crash, Striking Parallels, Willem
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Taleb: Focus on Special Trades in Selloff Misguided

Friday, May 14th, 2010

Nassim Taleb, professor at New York University and author of “The Black Swan: The Impact of the Highly Improbable”, talks with Bloomberg’s Erik Schatzker about the May 6 stock market selloff and his investment strategy. Taleb also discusses the drivers for the financial crisis, the U.S. economy and the performance of Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke.

Source: Bloomberg (via YouTube), May 13, 2010. (Hat tip: The Big Picture)

Tags: Big Picture, Black Swan, Bloomberg, Economy, Federal Reserve, Federal Reserve Chairman, Federal Reserve Chairman Ben Bernanke, Financial Crisis, Focus, Hat Tip, Investment Strategy, New York University, Special Trades, Stock Investment, Stock Market Selloff, Swan, Timothy Geithner, Treasury Secretary, Youtube
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Must Read: Michael Lewis’ Latest Memo To Lloyd Blankfein

Wednesday, May 12th, 2010

Blaming Merrill Might Set Goldman Sachs Free, by Michael Lewis, originally posted in Bloomberg

To: Lloyd Blankfein

Re: Winning at Ethics, the Goldman Way

I have reviewed no less than seven times your entire episode on Charlie Rose.

Your artful simplicity, studied humility and former hairline all positively radiated against the set’s dark background.

As one of my lesser colleagues on the desk marveled, “Lloyd seemed almost human: Why?” To which I replied, evenly: “because he finally read my last memo.”

Of course there was no reason you should look to one of your own traders for advice. But now that you have, we must proceed quickly. American public opinion is volatile; our exposure to it is peaking, and it will be more difficult than usual to create the illusion for American mortals (or as we like to call them, “The Morts”) that our business is in their interest, much less that we share anything in common.

This time, please, do not wait five months to internalize my new action items. They are:

No. 1: Implicate the rest of Wall Street, as quickly as possible.

It’s always unnatural to hear the name of Goldman Sachs in the same sentence as Deutsche Bank, much less Merrill Lynch. We must put aside our revulsion. The American people might enjoy seeing one firm being driven out of business by a criminal investigation. They’re less likely to allow for the destruction of every big Wall Street firm. They just forked over trillions to keep them afloat.

Delicate Decency

This job of putting our behavior in a new context — comparing it not to some broad universal standard of “decency” but to Wall Street standards — must be done delicately.

For example I was once hauled before a second-grade teacher and simply shouted, “You ill-paid, third-rate moron! I did nothing worse than what every other kid was doing! It is illogical not to punish them, too!”

The outburst did nothing to alleviate my situation, and probably made it more difficult than it needed to be for me to gain entry to Princeton. But the episode taught me one of the central tenets of the Goldman Way: far better to rig a system than to fight it.

Helpful Walks

Our public relations staff might quietly and helpfully walk even hostile reporters through some of the deals created by these other firms. Ditto our lawyers in their meetings with the Securities and Exchange Commission.

No. 2: Continue to use Warren Buffett, but don’t forget to pay him.

When Warren said that stuff the other day about wishing you had a twin brother so he could employ you both, he didn’t mean it as a sign of his undying admiration for you.

Remember: He said almost exactly the same sort of things about John Gutfreund, after Gutfreund had given him a sweet deal to rescue Salomon Brothers from oblivion. The moment Warren was forced to choose between Gutfreund and his money, he chose his money.

Don’t force him to make that choice. If you want more loud character references from Warren Buffett (you do) you must insure that he continues to think of you as profitable.

I don’t know if there are ways Goldman Sachs might simply give money to Berkshire Hathaway for free, but we should explore the possibility.

Hide the Props

No. 3: Hide, and hide from, the prop group.

If you must be seen in public with Goldman employees, make sure they are bankers and brokers, and not our proprietary traders. You did an excellent job on Charlie Rose of making it seem the prop group didn’t even exist.

We were mere “market makers” who helped our customers “get the risk they wanted.”

At the same time, but for different reasons, you should limit your private interaction with the prop traders, especially Jonathan Egol.

The SEC’s complaint focused on one of Jonathan’s Abacus deals and yet failed even to mention Jonathan. Instead they fingered the French guy.

At first I took it as just another sign of Mort stupidity. But now that the Justice Department has gotten involved, and is combing through all the Abacus deals, I wonder. Why is no one yet talking about Jonathan? Why is no one making noises about the deals structured for Jonathan — and not John Paulson — to short them? Is it possible that Jonathan has been helping them to understand our business? Just saying…

Our French Problem

No. 4: You need to address our French problem.

In a matter of weeks Fabrice Tourre has gone from non- entity to a potential asset (a “rogue trader” who might have gone quietly so that the firm might survive) to a huge liability (hero on Wall Street, who somehow has managed to portray himself as both a religious martyr and a mere cog in our machine.)

Going forward I suggest that our personnel department reexamine the French male’s ability to subordinate himself. In English there is no “I” in team. It turns out that the French use a different word: equipe.

Our international people should have known this. At the very least they should have been queasy about hiring guys who look as if they’d rather be wearing espadrilles.

‘Things Like Ethics’

No. 5: Be careful not to say or do anything now that will constrain our ability, after this crisis has passed, to do whatever we want.

The other day, on your emergency conference call with our customers, you said that you wanted Goldman to be seen as a “leader in things like ethics.”

I couldn’t have put it better myself. If in the future we fail to be a leader in ethics we can point to your statement as evidence that we never intended to be a leader in ethics, merely in “things like ethics.”

To that end, I intend to compile a list of things like ethics, in which we might strive to be a leader, without risk to our profitability.

Tags: American Mortals, Bloomberg, BRIC, Charlie Rose, Criminal Investigation, Dark Background, Decency, Deutsche Bank, ETF, Five Months, Gold, Goldman Sachs, Grade Teacher, Hairline, Humility, Lloyd Blankfein, Merrill Lynch, Michael Lewis, Outburst, Public Opinion, Revulsion, Seven Times, Trillions
Posted in Gold, Markets | No Comments »

Gold: Euro, China and Goldman Sachs

Monday, April 19th, 2010

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Gold fell the most in two months as the SEC’s action against Goldman Sachs (GS) spurred investors rushing out of riskier commodities and into perceived safer assets such as the U.S. dollar. Futures for June delivery slid 2% in one day to $1,136.90 an ounce.

Paulson Linked to Goldman’s Case

Goldman Sachs, the largest U.S. commodity broker, is charged with defrauding investors with a financial product tied to subprime mortgages by the Security Exchange Commission (SEC). In addition, hedge fund Paulson & Co. is also mentioned by the SEC, but not charged, in connection with the Goldman Sachs matter.

Paulson & Co. is the largest institutional holder of the SPDR Gold Trust (GLD) with about 8.4% stake, whereas Goldman Sachs also holds the 11th largest stake at 0.6% in the fund, according to Bloomberg data. SPDR is world’s biggest exchange- traded fund backed by physical bullion with a record gold holding of 1,141.041 tons as of April 15.

Goldman & Paulson Massive Gold Positions

Paulson’s high-profile bets have partly help drive gold to record-high prices above $1,200 an ounce. Although no charges were brought against the hedge fund, the double whammy news weighed on gold, and prompted some concern in the commodity markets, since Goldman Sachs is a major player with massive positions in all commodities including gold, silver and crude oil.

An Overdue Technical Correction

Typically, when market confidence is shaken by events such as the SEC Goldman suit, it should spell bullish for gold — an independent store of value. However, even before the Goldman news, gold, which rallied to a four-month high of $1,170.70 on April 12, was poised for a technical correction. So, the Goldman news most likely just triggered an exit opportunity for short-term traders to lock in profits from recent gains.

Gold-Euro Affair by PIIGS

Gold futures have been in an uptrend recently and rallied more than 11% from a multi-month low in February. The metal remains near record highs in euro and pound more on account of the currency weakness, and not due to the performance of the metal itself.

Both the euro and sterling pound had declined around 6% against the dollar in the first quarter of 2010, as the U.K.’s and PIIGS countries fiscal deficit crossed the 12% mark of respective GDPs, much higher than the EU’s prescribed limit of 3%.

With investors rotating out of the euro and into alternative assets like gold and the U.S. dollar on concerns of the Greece debt crisis, the historically negative correlation between gold prices and the dollar index has been broken since last December.

Instead, gold is now trending more positively with the dollar and inversely with the euro. (Fig. 1)

Watch EUR/USD

Over the near term, gold will keep looking to the dollar/euro relationship for direction with the euro dictating gold’s price.

The ongoing Greek debt saga has been a key driver of investors risk appetite. The EU already indicated Portugal may need to enact additional measures if it’s to cut its budget deficit.

Concerns of further fiscal crisis contagion into other members in the European Monetary Union could seal the euro’s fate of a continuous downward spiral against the dollar in the near term.

However, given the mountainous US deficits, it looks likely gold could reach record (nominal) highs in dollars as well in the medium term.

Technical Indicators

The U.S. Commodities Futures Trading Commission (CFTC) report indicated speculative financial investors seem to have become increasingly reserved and have been trimming their net-long positions in recent weeks. Commercial participants, who accounted for 51.3% of open interest, held net short positions at the end of March.

A further increase in the net short position, coupled with the negative sentiment stemming from Goldman/Paulson could put the gold price under pressure and test the psychologically important $1,100 mark.

For the time being, a dip below the $1,100 should provide investors with a buying opportunity and a rise above $1,150 would serve as a profit-taking signal. (Fig. 2)

Technicals aside, gold’s long term outlook is further solidified by a couple of new “China factors.”

China Gold Demand to Double

Gold demand in China has steadily increased since 1992 accounting for 11% of global gold demand in 2009. The World Gold Council forecasts demand doubling in the next 10 years from $14 billion to $29 billion on rising jewelry and investment demand.

Currently China’s per capita gold consumption level lags most other major gold buying countries. Although China is the world’s largest gold producer, rising domestic demand for gold outstripped domestic supply by 109 metric tons last year. This shortfall creates a “snowball” effect as China’s gold industry has to rely on imports, the World Gold Council said. (Fig. 3)

Boosted By A Stronger Yuan?

Meanwhile, some analysts also think a stronger yuan could be a catalyst to spur China’s gold demand. China might revalue its currency–the yuan or renminbi–after a recent meeting between U.S. Treasury Secretary Timothy Geithner and Chinese vice Premier Wang Qishan. Some analysts argue that the yuan is undervalued by as much as 40%.

A stronger yuan could support higher gold prices as the precious metal becomes cheaper to buy. Beijing has been encouraging citizens to buy gold and silver, a rise in yuan would certainly facilitate more buying.

According to the Associated Press, China let the yuan appreciate almost 20% between 2005 and 2008 during which gold prices touched $1,000 an ounce for the first time.

Underpinned By Fear & Uncertainty

Although it would seem that the Goldman-linked SEC case single-handedly killed the price of gold last week, as discussed here, it was only a catalyst to a technical correction that was overdue.

The fact remains that in times of uncertainty, investors historically turn to gold as a hedge against inflation and unforeseen crisis since gold is one of the very few asset classes that is not someone else’s liability.

Many experts argue that gold is not an effective hedge against inflation since the then-record $873 an ounce established in 1980 should appreciate to $2,287 in terms of today’s dollar.

However, fear of any sort usually does translate into higher gold prices. One hypothesis is that the seemingly slow and steady inflation is not explicitly overt enough to cause an overwhelming fear of inflation yet. Nevertheless, the record government debt levels and monetary printing machines will most certainly heighten investor’s inflation concerns and push gold prices much higher over the long term. (Fig. 4)

Tags: Bloomberg, Bullion, China, Commodities, Commodity Broker, Commodity Markets, Crude Oil, Double Whammy, Exchange Traded Fund, Exit Opportunity, Gold, Gold Euro, Gold Futures, Goldman Sachs, Hedge Fund, Independent Store, Market Confidence, Ounce, Sachs Gs, Security Exchange Commission, Spdr, Term Traders, Uptrend
Posted in Commodities, Markets | No Comments »

Jim Rogers Bullish Commodities, Gold

Friday, April 9th, 2010

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Jim Rogers discusses his views on commodities, and gold.

Rogers says about commodities bubble-talk, “What kind of bubble can it be if nobody owns it?” He says someday there will be a bubble in commodities, that by 2019 or 2020, people will be shrieking to own commodities.

He is bullish on gold, says it will go higher, not to sell it right now (if you own it), he owns it, but will not say whether its time to buy, that he’s not smart enough to know “when?” He jokingly leaves that to Bloomberg’s other guests who come on all day.

Rogers recalls speaking at a money manager conference in Prague, where polling showed that “76% of the audience had never owned gold in their portfolios – imagine that; so someday only 6% of them will claim they never owned gold.” He continues, “That’ll be the time to sell gold.”

“What I will say is that as long as you have all the people running the Western economies, like Bernanke, commodities and gold have a wonderful future. They’re gonna print money ’til we run out of trees.”

Rogers refuses to make any predictions about where gold will go, but says that he expects gold to be at least $2,000/oz. by the end of this decade, maybe even higher.

Source: Bloomberg via Youtube, April 7, 2010

Tags: Audience, Bloomberg, Commodities, Decade, Gold, Gold Commodities, Higher Source, Imagine, Jim Rogers, Money Manager, Portfolios, Prague, Print Money, Recalls, Rogers Email, Sell Gold, Trees, Western Economies, Wonderful Future, Youtube
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James Grant Lambasts Greenspan

Thursday, April 8th, 2010

James Grant, editor of Grant’s Interest Rate Observer, talks with Bloomberg about former Fed Chairman Alan Greenspan, specifically about testimony by the “Maestro” in front of the Financial Crisis Inquiry Commission hearing. (Click here to listen to Grant’s interview of last week about the credit quality of US Treasuries.)

Here is the video schedule:

0:15 Greenspan needs to be liked, “He’s just a guy in a business suit”

1:03 Greenspan might say he is against central planning, but he actually loves it via setting interest rates

3:00 Greenspan seen as a savior via his rate, encouraged risk

3:50 Greenspan came in as Ayn Rand’s acolyte, left as a panderer to power

6:25 The way Greenspan thinks is as a theoretical economist, and he disdains those financial thinkers who believe they were right

Source: Bloomberg (via YouTube), April 7, 2010 (hat tip: Clusterstock – Business Insider).

Tags: Acolyte, Alan Greenspan, Ayn Rand, Bloomberg, Business Insider, Business Suit, Chairman Alan Greenspan, Credit Quality, Fed Chairman, Financial Crisis, Hat Tip, Inquiry Commission, Interest Rate Observer, James Grant, Panderer, Savior, Thinkers, Treasuries, Video Schedule, Youtube
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Pressure Increasing on China to Revalue Yuan; What Can Go Wrong?

Wednesday, March 17th, 2010

By Michael ‘Mish’ Shedlock

Pressure on China to do something about its allegedly undervalued currency is mounting by the day. Please consider the following articles.

World Bank Calls For Stronger Yuan

The World Bank Says China Must Pare Stimulus to Counter Bubbles

The World Bank indicated that China, the world’s third biggest economy, should raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to help damp inflation expectations.

The nation’s “massive monetary stimulus” risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, the Washington- based World Bank said in a quarterly report on China released in Beijing today. The group raised its economic growth forecast for this year to 9.5 percent from 9 percent in January.

The World Bank’s call echoes the assessment of private economists — analysts at Morgan Stanley this week said higher reserve requirements for banks may be “imminent” and interest rates could start to climb as early as next month. China’s economic rebound has also sparked increasing calls for an end to its exchange-rate peg to the dollar, adopted in mid-2008 to help shelter exporters amid the global recession.

Senate Considers Currency Manipulator Regulation

Bloomberg is reporting Senate May Force Obama to Take Tougher Yuan Stance

Five senators including Charles Schumer of New York and Lindsey Graham of South Carolina introduced legislation yesterday to make it easier for the U.S. to declare currency misalignments and take corrective action. Even if the bill stalls, it may have “ripple effects” that lead the Treasury Department to declare China a currency manipulator, William Reinsch, president of the National Foreign Trade Council, said.

Obama’s goal of doubling U.S. exports in five years depends on his ability to get China to raise the value of its currency, said Sherrod Brown, an Ohio Democrat and co-author of the legislation. China’s intervention in currency markets to keep the value of the yuan, or renminbi, at a set value acts as a subsidy to exports and tax on imports, Brown said at a news conference yesterday.

Senator Debbie Stabenow, a Michigan Democrat, and Sam Brownback, a Kansas Republican, are also supporting the legislation. Graham is a Republican and Schumer is a Democrat.

The senators said the U.S. recession could boost the political prospects for the legislation, which Schumer has proposed in various forms since 2003. Schumer said the Senate proposal will be attached “very soon” as an amendment to “must-pass legislation.”

“The only way we will change them is by forcing them to change,” Schumer said.

The yuan is undervalued by as much as 40 percent, which is “blatant protectionism,” Bergsten said. Brown and Schumer quoted the analysis of Bergsten and Nobel Prize winning economist Paul Krugman in support of their efforts.

Business Sours On China

Please consider Business Sours on China.

China’s relationship with foreign companies is starting to sour, as tougher government policies and intensifying domestic competition combine to make one of the world’s most important markets less friendly to multinationals.

Patent rules imposed Feb. 1 threaten to increase costs in China for foreign innovators in industries such as pharmaceuticals, and let authorities force foreign drug companies to license production to local companies at state-set prices.

A year ago, in a move foreign critics called protectionist, Chinese regulators rejected a bid by Coca-Cola Co. for China Huiyuan Juice Group Ltd., saying it could crowd out smaller companies and raise consumer prices. The two combined held just a fifth of China’s juice market.

In July, four executives of Anglo-Australian mining giant Rio Tinto were detained, initially accused of stealing “state secrets,” amid tense negotiations between global miners and China’s steel industry over iron ore prices. Rio Tinto denies wrongdoing by the men, who await trial on reduced charges of bribery and theft of commercial secrets.

Google Inc.’s woes highlight the angst. The search company, long troubled by Chinese censorship rules, threatened Jan. 12 to depart China after it said a Chinese hacking attack penetrated its computer network. Related attacks hit dozens of other multinationals. Google is expected soon to close its Chinese site, Google.cn., leaving local companies dominating an Internet market of 400 million users.

“The Google issue has had a crystallizing effect,” says Lester Ross, managing partner in Beijing for U.S. law firm Wilmer Cutler Pickering Hale and Dorr. “It raised the consciousness of government and of the boardrooms and other stakeholders” about the difficulties of doing business in China, he says.

Krugman Wants To Take On China

Inquiring minds are reading Taking On China by Paul Krugman.

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.

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It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

Looking At Half The Equation

For starters, Krugman conveniently ignores one side of the equation.

A sinking dollar is good for exports, however, given China’s regulatory policies as noted in Business Sours on China, it’s not at all clear exports to China would rise by much. Indeed, I suspect that China’s regulatory restrictions are a far bigger impediment to trade than currency fluctuations.

Furthermore, one cannot (or at least should not) ignore what would happen to the price of imports. A falling currency is not a free lunch.

While I agree with Krugman that China would not dump US Treasuries, the idea that the U.S. has China over a Barrel because is preposterous. Mutual deadly embrace with unbalanced winners and losers is more like it.

What China Can and Cannot Do With Reserves

Please consider What the PBoC cannot do with its reserves by Michael Pettis.

It is a real toss-up as to which generates more bizarre comment in the international press: Beijing’s long-feared dumping of US Treasuries, or the use and value of the PBoC’s central bank reserves. The revelation last week that Chinese holdings of US Treasury obligations fell in December by $34.2 billion, to $755.4 billion, generated a frisson of fear and excitement, leading one prominent newspaper to worry that “If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.”

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit. And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets. Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why? Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price. What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar. In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear. The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Here is where things get interesting. China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100. To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money.

So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment. …..

… if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms. Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations. And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss. It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Yuan is Undervalued by as Much as 40 percent?!

For the sake of argument, let’s assume The RMB is undervalued by 40%. Who is the winner?

To answer the question let’s return to a snip from Pettis:

“generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio. The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.”

If that is true generally speaking, then the US is a beneficiary now, generally speaking. This implies we should be careful of what we ask. However, the situation is more complex because as Pettis explains there are individual winners and losers:

“..it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.”

Shock Effect

Let’s consider the global shock effect of a sudden large revaluation of the Renmimbi. The key is the RMB does not float. To get a 40% rise in valuation, China must buy or sell unlimited amounts of RMB against the dollar to maintain the desired price. That might mean a huge hike in Chinese interest rates to make holding the RMB attractive.

In turn, sharp interest rate hikes would likely cause a huge slowdown in China, decreasing China’s demand for imports. This is yet another factor that Krugman and those crying “currency manipulator” miss.

And should the US impose a revaluation via tariffs, I would like to point out a little thing called Smoot-Hawley.

By the way, I am all in favor of a huge slowdown in China. I think China is on an unsustainable course, and the sooner and harder China slows the better for everyone in the long run.

However, the consequences of such a slowdown would be huge on the commodity exporters like Canada and Australia. Moreover, a slowdown in trade would slow global consumption.

I happen to think those are necessary adjustments along with more debt writeoffs, but believers in free lunches and Keynesian claptrap sure won’t see it that way.

Hopefully this gives you a bit more of an idea as to just what might go wrong with all these simplistic “the Yuan is 40% undervalued – so label China a currency manipulator” ideas floating around.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Asset Price, Bad Debts, Bloomberg, BRIC, Canada, Charles Schumer, China, China Beijing, Commodities, Corrective Action, Economic Rebound, Economic Trend, Global Recession, Government Projects, Housing Bubble, Inflation Expectations, Lindsey Graham, Michael Mish, Mish Shedlock, Morgan Stanley, Private Economists, Ripple Effects, Sherrod Brown, Treasury Department, Trend Analysis, Yuan
Posted in Canada, Canadian Stocks, China, Commodities, Markets | No Comments »

Exclusive: Jim Rogers is Long the Euro

Wednesday, March 10th, 2010

This article is a guest contribution by Damien Hoffman, WallStreetCheatSheet.com.

Jim Rogers is one of the best global investors of all-time. Last time we chatted a couple months ago he was sleeping soundly with his investments in commodities. Before Bloomberg interviewed Jim this morning, I caught up with him last week to get some high level perspective on the current issues unfolding in the European Union …

Damien Hoffman: Jim, Do you think the EU will survive economically and/or politically through this entire debacle?

Jim: Well I’m long the Euro because I expect them to come through this one okay. Either Greece is going to be papered over and they’ll give a blast to the Euro, or they’re going to let Greece go bankrupt. In my view, this is what they should do because then people would say, “Wow. They’re serious about sound economies in Europe.” That would make the Euro very strong. Then people would know they are not just going to print money or paper over failure.

Either way, I think there’s probably a rally coming. There’s a huge short position in the Euro and whenever there’s been a huge short position in anything, it’s sometimes profitable to go to the other side. So, I am long the Euro because I think there are too many pessimists.

Maybe Greece will go bankrupt and the Euro will collapse before people realize, “That’s good … that’s not bad.” Sometimes it takes a lot for perception to become reality or reality become perception.

Damien: What other countries are you monitoring to make sure the situation isn’t going to spread or get out of control?

Jim: I’m trying to watch the whole world. We cannot be very successful investors if we don’t know what’s going on everywhere. All of a sudden you’ll something like Iceland will show up and you’ll get killed because you didn’t know that Iceland even existed. Usually these things come out of the blue from some place we’re not thinking of.

Damien: Do you think Greece will be the first to tumble?

Jim: I would suspect that the U.K. is more likely to suffer before Greece, but who knows. Maybe it’s time for all of them to collapse and come down together.

Damien: Speaking of collapsing together, do you think the creditor-consumer model — as used by the Chinese with the US and the Germans with the Greeks — has been proven unstable and countries should be moving more passionately towards developing organic manufacturing and consumption economies at home?

Jim: The idea of economies built on consumerism has been discredited many times. The last ten or twenty years people have been shouting, “Oh gosh! Thank goodness for the American consumer.” However, no economy has ever been built on consumption for the long term.

The only way you build an economy is through savings and investments. Look at Dubai. The basic economic model in Dubai was to build an economy based on real estate speculation. That cannot work. You’ve got to have savings, investing, and productive capacity.

It’s all wonderful if we can go to the disco every Saturday night or go drinking by paying our bills with transfer payments. But that doesn’t do anything for long term productivity or competitiveness. Also, guys who build tanks have fun building the tank, but that tank then goes out in the sun or rain to rust. It doesn’t do anything for future productivity. The only way to build an economy long term is to save and invest while building infrastructure and productivity. Nothing else has ever worked.

Damien: Which countries are doing things correctly?

Jim: There are some doing better than others. The largest creditor nations in the world now are China, Korea, Japan, Taiwan, Hong Kong, and Singapore. That’s where the assets are. There are hundreds of billions of dollars in these countries because they’ve been doing something right.

You know who the largest debtor nations in the world are? I assure you they’re not in Asia. They’re in the West.

The future has always belonged to the people who’ve got the assets — the people who’ve built up savings and investing. Throughout history, we have never heard people say, “Gosh. Look over there at all those debtors. Why don’t we go over there and join those debtors?”

Instead, throughout history people have said, “Look over there where all the assets are.” People have always said they want to go where the assets are, not where the debts are. That’s what happened in America etc., and that’s what’s going to happen in the future as well.

Damien: Jim, thank you very much for updating us on your view.

Jim: You’re welcome.

Tags: Bloomberg, Commodities, Current Issues, Debacle, Euro, Europe, European Union, Failure, Global Investors, Greece, Hoffman, Investments, Jim Rogers, Last Time, Level Perspective, Out Of The Blue, Perception, Pessimists, Rally, Short Position
Posted in Bonds, Commodities, Markets | No Comments »

PIMCO on Emerging Market Debt, Greece

Friday, February 12th, 2010

PIMCO’s Gomez, co-head emerging markets debt, says there are structural concerns about Europe complicating aid for Greece in the short term, but that the bailout issue will be resolved. In any event, the euro was overvalued and a due for a correction. He also says that ultimately, success will depend on Greece.

Source: Bloomberg (Youtube)

Tags: Bailout, Bloomberg, Emerging Market, Emerging Markets, Europe, Gomez Co, Greece, PIMCO, Success
Posted in Markets | No Comments »

The Dollar Carry Trade is Collapsing

Friday, January 22nd, 2010

This article is a guest post by Vince Fernando, The Business Insider.

Dollar strength at the end of 2009 sent the dollar carry trade (where by one borrows in dollars, then parks the proceeds in higher yielding assets) into a tailspin. This is why even small upward moves in the dollar could instigate substantial selling for 2009’s star currencies. For example, for the Australian dollar shown to the right.

Bloomberg: Funding the carry trade with the greenback lost money in December for the first time since February as the U.S. currency gained 4.8 percent against the euro amid growing confidence in the U.S. economy and expectations that the Federal Reserve will raise borrowing costs by June. Futures trading on Dec. 31 suggested a 62 percent chance the Fed would increase its benchmark to at least 0.5 percent by mid-year from a range of zero to 0.25 percent, up from 30 percent in November, Bloomberg data show. The Bank of Japan’s target rate is 0.1 percent.

Buying and selling high- and low-yielding currencies to take maximum advantage of global rate moves gained 19 percent from February to November, the carry trade’s best nine months since 2003, a Royal Bank of Scotland Plc index shows. The index fell 0.9 percent in December.

Few engaged in such an arbitrage will want to hang around should last year’s prevailing weak-dollar expectations be substantially reversed by persistent dollar strength.

[AA] Looking at the chart below of the dollar index, you can see that the dollar has rallied since the end of November, as a result of the accumulation of large short positions, not being covered. This has been a very profitable trade on both a currency pairs as well speculation in last year’s winning trades.

Currencies fared vary well against the dollar from an exchange rate standpoint as you can see in the following table:

* reflects the percentage change in the value of the non-USD currency compared to USD

Is it really a surprise that risk assets (commodities, the Canadian and Aussie dollars, equities, emerging markets) are selling off as institutional and hedge fund traders unload this increasingly squeezed short trade?

Read Bob Janjuah’s updated outlook for more insight on the short squeeze raising the dollar’s value – Janjuah points out that Senator-elect Scott Brown’s GOP victory in Massachusetts upsets Obama’s applecart so much so, that the resulting backlash will be for Obama to speed up plans for fiscal tightening, which means possibly a more rapid windup of the Fed’s quantitative easing, monetary tightening later this year.

Axel Merk puts it nicely, saying “In that context, the conventional wisdom that a country needs to have economic growth to have a strong currency is, in our assessment, wrong. Such a relationship only applies to countries that depend on foreigners to finance their deficits. In the U.S., foreigners finance the twin deficits; one of the reasons why the U.S. has economic growth as a top priority is to entice foreigners to keep financing U.S. deficits. Australia also has a current account deficit and, as a result, has a currency that is sensitive to economic growth prospects. Japan, however, traditionally finances its deficits domestically; as a result, the value of the yen is not very sensitive to changes in growth forecasts. The same can be said for the euro zone: because the euro zone does not have a significant current account deficit, in our assessment, the euro can do well in the absence of economic growth.

Source: StockCharts

Add my twitter feed: @vincefernando

Tags: Arbitrage, Australian Dollar, Bank Of Japan, Bank Of Scotland, Benchmark, Bloomberg, Business Insider, Canada, Carry Trade, Commodities, Currency Pairs, Dollar Index, Dollar Strength, Emerging Markets, Federal Reserve, Futures Trading, Global Rate, Greenback, Maximum Advantage, Nine Months, Percentage Change, Profitable Trade, Royal Bank Of Scotland, Royal Bank Of Scotland Plc, Tailspin, Target Rate, Weak Dollar
Posted in Commodities, Markets | No Comments »

China’s trade balance points to inflation

Thursday, January 21st, 2010

The Customs Administration announced record trade flows in and out of China in December. Specifically, exports grew at a 17.7% annual pace, while imports surged 55.9% over the year. This is a remarkable one-month rebound; reported export growth beat consensus expectations by a factor of 3.5 (+ 5% export growth and + 32.5% import growth, according to Bloomberg).

China is experiencing robust domestic demand growth, as illustrated by the surge in imports. Furthermore, there is likely significant price pressure built into this report since the data are measured in nominal $USD. The December trade report suggests that inflation pressures are underway in China’s economy; expect a big jump in coming inflation reports.

I wouldn’t be surprised if the government allows the yuan to appreciate sooner, rather than later, in light of this report.

Rebecca Wilder

Tags: Bloomberg, China, China Economy, China S Economy, China Trade, Consensus Expectations, Customs Administration, Emerging Markets, Import Growth, Inflation Pressures, Inflation Reports, Pace, Rebecca, Rebound, Report Suggests That, Trade Balance, Yuan
Posted in Canadian Stocks, China, Markets | No Comments »