By Marshall Auerback, a market analyst and Research Associate at the Levy Institute
I’m fundamentally a deflationist at heart on the question as to how this mega moral hazard bubble finally resolves itself. This, in spite of the strong sudden explosive rise in the December US household measure of employment, (which has brought the smoothed household survey job growth up towards the stronger payroll survey job growth and seems to point toward further rate rises being engineered by the Federal Reserve as we move forward in 2016).
So why didn’t bonds plummet (and yields soar) last Friday, following the December rise of 485,000 jobs, which took the 3 month average to 329,000? (Prior to this report household survey employment growth averaged 119,000 a month for the nine months through November and 95,000 for the six months through November. Now the six-month average is 201,000 and the nine-month average is 177,000. ) For that I think we have to look toward China.
Even though China’s most recent data has shown signs of stabilization (and the current turmoil in the Chinese market will likely provide more Chinese policy stimulus via further overinvestment, which could perpetuate this capex bubble in the short term) it is likely that the US bond market is paying closer attention to the gradual unwinding of the country’s historically unprecedented investment ratio of around 45% to GDP. That ratio (down from a peak of 55%) suggests that China is poised to embark on a powerful accelerator multiplier dynamic to the downside. Add to that ongoing dollar strength, which has inflicted further deflationary pressures on resource producers, most particularly those who have borrowed dollars against declining resource revenues, all of which has put pressure on commodity prices.
And, as my friend Doug Noland has astutely noted in his most recent Credit Bubble Bulletin, “China’s reserves provide a crumbling foundation for confidence – internationally as well as domestically. Chinese officials might now seek to orchestrate a major currency devaluation and system reflation (comparable to past moves by the U.S., Japan and Europe). But they will face the traditional EM problem of flagging confidence – in their currency, in their banking and financial systems, in their economic structure and in policymaking. They risk further inciting destabilizing outflows – and the more aggressive Chinese fiscal and monetary stimulus the more precarious the ‘capital’ flight issue will become.”
While the commodities collapse has likely been exacerbated by the leveraged speculating community continuing to unwind several crowded “risk on” trades, there is a fundamental basis for the declines as well: namely the market intuiting a big devaluation of the RMB in the near future. Perhaps Beijing’s policy makers are contemplating that a big one-off devaluation of the RMB (15% ?), will put a floor on the “death by a thousand cuts” outflows to their currency, as well as helping to stabilize their dwindling foreign exchange reserve position once and for all. That’s certainly a risky approach for China’s policy makers, as it might well have the opposite impact.
But Beijing may have no choice. Authorities are quickly becoming fearful of pissing away all their international reserves. The wall of money from China may be coming to an end. They have the challenging task now of aggressive stimulus without inciting additional capital flight. A big devaluation to boost exports (and buttress forex reserves) might be seen as the preferred course of action, particularly given that China’s foreign debt position is relatively stable at around 10% of GDP.
It would not be the first time that China has gone in the direction of an aggressive devaluation. Today’s investors have short memories, but China undertook a huge cumulative devaluation of the RMB of 60% between 1992-94, which rendered the Tiger economies completely uncompetitive and turned their large current account sures into deficits very quickly. That was a key (but little appreciated) factor that helped to lay the groundwork for the 1997/98 Asian financial crisis.
So to return to the initial question posed, in spite of the strong employment data coming out of the US last Friday, I still think the deflationary tsunami coming from China is what is keeping US bond yields low, and China seems like the biggest reason for that If a bigger devaluation comes, China might also find itself forced to impose yet stricter capital controls (in spite recent liberalizing moves the past few years).
And that’s why I suspect that bond yields didn’t go up on Friday, in spite of the “strong” employment data in the US. Because the markets at some level intuit this huge deflationary blowback coming from China. The ongoing declines in the Chinese markets this week suggest that the recent interventions have not helped, given the magnitude of the challenges faced by Beijing.
One last point: The idea that China will behave “responsibly” is a crock. They have huge asymmetric political problems. If we get policy wrong in this country, voters have the right to pursue a change of government. Not so in China. So if their policy makers get it wrong, they likely go to the salt mines or (even worse) face firing squads. So the political imperatives point to Beijing looking out for China first, the international economic consequences be damned. What an irony a big devaluation would be, considering that years ago the “informed consensus” universally believed that the next big move for the RMB would be a substantial revaluation.