All the blame on China

Outlook:

“If you can keep your head when all about you/Are losing theirs…” and blaming it on China. Traders are ninnies sometimes and this is one of them. Bloomberg writes that of the top worries of financial professionals at the IMF talks, a sharp slowdown in China and ensuing emerging market crisis are at the top of the list. Next is the effect of an EM crisis on developed economies and finally, hot money capital flows that effect exchange rates. In a word, China.

But we honestly do not know whether data on China is of any use at all, and that is true of the seeming drop in inflation today and it will be true of next Monday’s GDP number, too. Wall Street in Advance’s Lynne astutely notes that perhaps forecasters are not taking into consideration the Tianjian warehouse explosion that closed the port and almost certainly worsened the import number yesterday. Besides, one indicator of consumer confidence is excellent performance at the Macau casinos over the Golden Week holiday, revenues up 45% over Sept. Equity analysts who had upgraded casinos are feeling pleased with themselves. We are not sure casino outcomes are the most representative data, but never mind. The point is we simply do not know how sharp the Chinese contraction is or what the knock-on effects are going to be, and to panic ahead of time is silly. Respond, yes—panic, no.

In finance, when an Event is universally expected, the standard operating procedure is to build it into the price so all the damage in done well ahead of the data release, which is why we get “sell on the rumor, buy on the fact.” It’s the unexpected Event that shocks the market and causes turmoil, including pinball effects. Evidently nobody told these tidbits of market lore to the latest bunch of equity traders because they persist in feeling shock at well-expected events (like today’s Chinese inflation). On the other hand, the FX market readily absorbed the drop in eurozone industrial production. This doesn’t necessarily make the FX crowd any smarter than the equity crowd (although maybe it does), but it shows an uneven market price response to data. The net effect is to give Chinese data disproportional weight no matter what it is. The only historical equivalence we can readily come up with is the start of the two Iraq wars, when the dollar rose every time the US rattled its sword.

This puts an additional burden on China to be very, very careful. Fortunately, the Chinese know it. This is why, probably, China is about to extend onshore FX trading hours to overlap with its new London exchange, something the IMF named as the source of liquidity problems. According to Reuters, the local market closes at 4:30 pm local time and will soon keep going to 11:30 pm, which is 5:30 pm London time. It’s still a command-economy currency that does not float freely, but obviously the machinery is being put in place to make trading the yuan smoother--and to improve its popularity.

Here’s the question: when the FX market can respond to Chinese data appropriately, meaning in the free-market way we respond in the majors today (like yesterday’s sterling crash on negative inflation), does that mean the equity crowd will be less influenced? We say, yes, probably. It’s almost as though the world needs an outlet to express a response to fresh data and FX is the first opening. In the absence of a real or at least adequate outlet in the form of FX, the response goes sniffing around for another place to express itself and finds it in equity markets. For example, in earnings season, the S&P should be responding primarily to earnings, not to China. We already know about the Chinese and general EM slowdown. For the US indices to fall yesterday on Chinese data is to give a secondary factor too much weight. To be fair, we also had crummy bank earnings, but the FT says China was more important than earnings, and that’s what we see on the chart, too, Will that stop when the yuan is freely traded? No, but it will be reduced. Probably.

As for the Fed staying its hand because of the global slowdown in general and China in particular, we have another two Fed Govs saying the rate hike decision should be postponed beyond this calendar year. Brainard and Tarullo, both voters on the FOMC, prefer to wait. They join two regional govs, Chicago’s Evans and Minneapolis’ Kocherlatoka, and bring the opposition to four. The WSJ quotes a professor who calls it a “revolt.” But Yellen and Fischer together are strong leaders, and they have the support of Richmond Fed Lacker and St. Louis Fed Bullard. Meanwhile, separately, “The Fed said Tuesday, in a scheduled release, that eight of the 12 regional reserve banks had supported a September increase in a secondary but symbolic rate called the discount rate.”

Oh, dear. Might we get some clarity from the October 27-28 FOMC? Probably not. In the meanwhile, we can watch data releases. Today it’s retail sales (reflecting consumer confidence), the Beige Book and PPI (yawn). Retail sales is the key item, and given auto sales, likely to be pretty good—but pretty good is a positive 0.3%. The other side of the forecast range is -0.1%. If we get the negative, the dollar will get a second strike to add to the two dovish Fed Govs and perception of discord at the FOMC.

There is no way this can be dollar-friendly. Plus, traders are looking forward to Thursday’s CPI, likely to show a drop by 0.2% in Sept. The FT notes the 50% probability of an Oct rate hike has now fallen to 6%, with March the new favorite at 56%.

What happened to policy divergence between the Fed and ECB that was supposed to push the euro to 1.10 or lower? Today the FT names the Bank of Montreal FX strategist who continues to see the ECB’s QE bringing the euro “back down to earth.” The forecast is for “$1.09 in three months and $1.07 in six months on simple policy divergence between the ECB and the Fed. Our buzz phrase on the euro is ‘resilient due to risk-off, but still a QE currency.”

Well, no. Or at least no until Draghi tells us otherwise, and he’s keeping mum. Traders take positions ahead of expected news, but March is too far away. We will see 1.1500 (the obvious options strike) and 1.1700 (the last high on 8/24) before we see 1.09. How much of the rise is short-covering and how much is outright favoring of the euro or disfavoring of the dollar is something we can never untangle. That’s why we have charts.