Chart Presentation: Trend Shift
The combination of additional easing from the Bank of Japan and the Fed’s commitment to hold interest rates at current levels for an extended period of time helped lift global equity and commodity prices.
Our view is that the Fed’s use the phrase ‘extended period’ is a bit of a misnomer. More accurately the Fed should state that it will keep the overnight funds rate between 0% and .25% until the markets tell them to do something different. Given that the markets have yet to do that... perhaps the Fed might be forgiven for assuming that conditions will not change appreciably in the near term. As things stand, however, we would not be surprised to find out that an ‘extended period’ of time actually means ‘until the June FOMC meeting’.
Below is a comparison between the U.S. Dollar Index futures and the ratio between the Morgan Stanley World-ex. USA Index and the Dow Jones Industrial Index. The World ex-USA/DJII ratio is essentially ‘everything else compared to U.S. large caps’.
Next we show the share price of Wal Mart and the ratio between Hong Kong’s Hang Seng Index and the S&P 500 Index .
The argument is that when the dollar begins to rise U.S. large cap stocks tend to outperform on a broad basis. In other words while there will always be stocks and markets that do better on average the DJII should rise relative to an index of global equities.
The last chart here makes a somewhat similar point but from a different angle. When the dollar turned higher around the end of October the share price of Wal Mart began to rise. WMT is, of course, a Dow component.
On any given day or week it may appear as China and Hong Kong are springing back to life and that the dollar is going to decline or that dollar strength really isn’t much of an issue. When you take a step back and look at the charts that we have shown you can see- hopefully- that the World ex. USA/DJII and Hang Seng/SPX ratios are still in down trends while the dollar and WMT remain in uptrends. As long as these trends hold then we will argue that it makes sense to avoid the trap of running back to those things that worked best through 2009.
At present there is upward pressure on the U.S. dollar, U.S. interest rates, and U.S. large-cap equity prices.
Equity/Bond Markets
March 16 — China and Japan, the two biggest foreign holders of Treasuries, reduced their positions of U.S. government debt in January as a measure of demand for American financial assets fell to a six-month low.
China remained the biggest owner abroad of Treasuries, even as its holdings dropped by a net $5.8 billion to $889 billion, according to Treasury Department data released yesterday in Washington... China has been a net seller of Treasuries for three straight months, the longest such stretch since the end of 2007.
The news story included above from Bloomberg was published earlier this week. The detail that we found interesting had to do with the fact that China had been a ‘net seller of Treasuries for three straight months’.
One could interpret this statement in a number of ways and we imagine that most would view this as proof that China was losing faith in the integrity of the dollar. From our point of view, however, what is likely means is that capital has already begun to move away from China.
To maintain a peg against the U.S. dollar China has to absorb net dollar-based capital inflows. In other words if a billion dollars of capital shifts into China then either the yuan would rise against the dollar, or, if the yuan were pegged, China’s holdings of dollars would have to expand.
We are over simplifying the issue, of course, but the point of our argument is that as long as China’s holding of Treasuries is expanding one could conclude that foreign-based capital still views investment in China in a positive light.
We have no idea how many billions of dollars have piled into China seeking to take advantage of the one-way bet on its currency. Based on July 2009 prices and current exchange rates the ‘Big Mac Index’ suggests that the yuan is 48% undervalued relative to the dollar. If true then converting dollars to yuan today makes absolute sense.
But... we suspect that there is another outcome looming on the horizon. The U.S. brands China as a currency manipulator, China responds by digging in its heels while refusing to lose face by revaluing the yuan, and the U.S. hits it with a broad range of fairly onerous tariffs. All of a sudden a one-way bet on a currency that simply has to rise turns into a capital flight rout.
Below we show the Hang Seng Index from Hong Kong along with the product of crude oil futures prices times the Australian dollar futures from 1996- 97.
The Asian crisis that hit the markets in the late summer of 1998 dated back to a reversal in the flow of capital from ‘towards Asian’ to ‘away from Asia’. around the start of 1997. In other words once oil prices and the Aussie dollar began to decline the Asian trend turned negative even though the Hang Seng Index moved on to new highs into the summer of 1997 before ‘crashing’.
Our thought is that if China’s Treasury holdings keep declining it probably means that capital began to shift away from China around the end of 2009 when the dollar started to rise. While we could be months, quarters, or even a couple of years away from a crisis we may find the problems facing the markets during 2011 and 2012 are directly related to money voting with its feet on its way out of China.
The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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