Off the cliff again

Outlook:

We will start thinking about the Fed again later today and tomorrow ahead of the 2 pm Statement. Friday’s Bank of Japan statement is too far away to worry about right now. For the moment, we need to worry about China again. The Shanghai dropping another 6.4% and setting off another round of global bourse losses--for the second time in six months –is a screaming danger sign. As several Chinese market players have told the Western press, confidence in the stock market has disappeared and even die-hards are exiting.

Last week George Soros told Bloomberg he blamed China as the “root cause” of the global bear market, naming excessive debt and deflation as the key risks. A hard landing is “practically unavoidable.” Chi-na’s size and vast reserves give it the strength to overcome its slowdown, but smaller economies will suffer from deflation exported from China. Soros did not name yuan devaluation as a central issue, but China responded as though he had, no doubt mindful of the Soros effect on the pound in 1992. He did say he was betting against the S&P 500, “Asian currencies” and commodity-linked currencies, although technically he retired from his firm a year ago.

While we always respect what Soros has to say, the more important factor in this little saga is the Chi-nese response. The FT reports the overseas edition of the People’s Daily says “Soros’s war on the renminbi and the Hong Kong dollar cannot possibly succeed — about this there can be no doubt.” Earli-er, on Saturday the official Xinhua news agency had a story railing against “those who want to bet on the ‘ultimate failure’ of the Chinese economy” and warning that “reckless speculations and vicious shorting will face higher trading costs and possibly severe legal consequences.”

Ah, but that’s the problem—in free markets, governments can’t punish traders for taking short positions outside their own borders. Within the borders, yes, with various regulations. Here we go again—China wants to be a player on the world stage but doesn’t like the rules. This is the biggest risk to the world’s markets—erratic anti-market measures accompanied by over-the-top rhetoric.

We are a little surprised not to see a rebuttal of the Bloomberg bombshell yesterday asserting capital outflows were $1 trillion in 2015. These are numbers compiled by Bloomberg, not reported by the gov-ernment. Bloomberg says “Outflows increased to $158.7 billion in December, the second-highest monthly outflow of the year after September’s $194.3 billion, according to estimates compiled by Bloomberg Intelligence. The total for the year soared more than seven times from $134.3 billion in the whole of 2014 to a record for Bloomberg Intelligence data dating back to 2006” to $1 trillion in 2015. Bloomberg also asserts “China’s foreign exchange reserves are seen tumbling $300 billion this year to the $3 trillion level some analysts say risks undermining confidence in the central bank’s ability to de-fend the currency, according to a Bloomberg News survey. Policy makers have been burning through reserves to reduce yuan volatility as the currency lost its status as a one-way bet on appreciation amid the slowest economic growth in a quarter century and an unexpected devaluation in August. The stock-pile of reserves plunged $513 billion last year to $3.33 trillion, the first annual drop since 1992.”

Other news outlets report the Bloomberg numbers as gospel and indeed, we have no reason to doubt the excellence or accuracy of the Bloomberg numbers. But let’s also acknowledge that China is engaging in all kinds of activities—in Africa, in Iran—about which we know almost nothing, and certainly not the financial effect. For all we know, China could double reserves by selling off commodity stockpiles. Do we really know how much gold China holds?

Bottom line, it doesn’t pay to underestimate China.

On another front, the Fed statement tomorrow will be parsed not only for hints about the next hike (if there is going to be one) and its timing, but also any mention of the dollar. The Yellen Fed differs from the Bernanke and Greenspan Feds by allowing consideration of the dollar. Those other Fed chiefs (and their respective Secretaries of the Treasury) treated it as a side-effect and certainly not a policy target (perhaps as a strict antidote to the 1970’s, when managing the dollar was an accepted policy stance, to disastrous outcomes).

In the Yellen Fed, though, we have a new committee on global imbalances and risks chaired by Mr. Fischer, who knows a thing or two about FX. Fischer has already stated his take on the US’ “responsibility” toward the rest of the world: yes, the US has such a responsibility but it’s limited, and best exercised by making the US economy as strong and resilient as possible. Technically, the dollar still comes under the purview of the Treasury. We have not heard anything worth reporting from Mr. Lew about the dollar. The last big Treasury statements are from the last century—Mr. Snow’s “let the markets decide” and Mr. Rubin’s “a strong dollar is in the US’ best interests.”

We say it’s unthinkable the Fed would take any action motivated primarily by the effect it would have on the dollar. The Fed’s mandate is to nurture employment and manage inflation. A fall-ing dollar would indeed generate inflation via more costly imports, but the flood of criticism (“currency wars”) that would come from even talking about wanting a weaker dollar would not be worth it. The US has been leading G7 for decades to eschew currency management and to avoid “beggar-thy-neighbor” policies. It’s all but a promise.

Besides, the US economy may be delivering disappointing results and some of them are due to the too-strong dollar, but the dollar is only hindering the recovery, not halting it. As BBH analyst Chandler told the FT, “I’m not sure the market’s idea of zero [rate hikes this year] is a better alternative.” Chandler is right. This is not to say the Fed won’t mention the dollar. But it is to say we shouldn’t read too much into it or start imagining the Fed will make policy with the dollar uppermost. The dollar is not uppermost to the Fed—it’s secondary.

It would take a massive, unimaginable crisis for the Fed to go into “risk management” mode and play the dollar card. And so far, the contagion from oil and China is perhaps a little less this time than at the beginning of the year. It’s probably foolish to count on earnings to overpower multi-market fear at this point, but you never know. All we need is a small break in those emergency-correlations for markets to recover some sanity on fundamentals.

In currencies, that will be when the euro loses some safe-haven moxie and falls back below support. The absence of any real upward momentum in the euro might be our signal to doubt this latest move. Stay tuned.

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