Chinese Monetary Policy vs. Inflation FIGHT!

*FX data updated on March 27th 2008

Policy makers in China have not only continued their anti-inflationary rhetoric, but have started acting on it. We have seen the RMB reach several new highs verse the USD in recent days (7.01). Additionally, Chinese authorities have increased reserve requirements for the second time this year by 50bp to 15.50%. It does not appear this news has settled too well with Chinese equities markets, which have experienced a significant sell-off from the combined fears of tighter monetary policy, a stronger RMB, and possible global slowdown. As a result, local investors seeking more attractive yields have started moving away from EQ and into the domestic fixed income market; yields have rallied accordingly. We expect this trend to continue.

Fears of a global economic slowdown and tighter monetary conditions have begun to show up in the SSE Composite...

Source: Bloomberg

This was not unexpected, as we outlined in an early posting, this how we expect Chinese policy makers to combat high inflation levels:

1) The Central Bank will increase interest rates, which it hasn’t done since December 07;

2) They will allow the RMB to appreciate at a faster rate;

3) They will implement new or stronger policies to reduce monetary growth. (i.e. Higher reserve requirements).

Additionally, we believe the government will continue to enforce its recent price control measures. With that said it is highly likely the Chinese government will continue increasing reserve requirements and continue appreciating the RMB at a faster rate. Given the recent weakness of the USD, the RMB has weakened substantially against the Euro, which probably implies European officials will begin placing pressure on the Chinese officials for quicker appreciation. We also expect to see increases in the Chinese reference rate, the last increase occurred at the end of December.

The Chinese Reserve Requirement Ratio has been increased steadily with inflation, and will continue to rise...

Chinese officials will continue to speed up appreciation of the RMB to combat inflation...

Investment Idea: We see potential upside in the domestic Chinese Steel industry. We have seen an increase in domestic demand as the country continue to develop and we believe the industry is ripe for consolidation. We may actually see the amount of Chinese steel exports decrease this year due to increased local demand, higher export tariffs, and an appreciating RMB. A reduction in Chinese steel exports could put upward pricing pressures on the global market. We also expect domestic steel makers to increase domestic prices as international prices rise. In fact, Baosteel has already announced price increases and may adjust prices on a monthly basis vs. quarterly previously. This of course will put further pressure on Chinese inflation. Which means it will be important to monitor to what degree government officials allow steel producers to pass costs to consumers. However, for steel, we see plenty of demand and a sticky supply. The bottom line is in 2008 look for higher steel prices, industry consolidation, and fewer exports from China (reducing the global supply). We believe this should directly benefit Brazil (ETF:EWZ), especially domestic iron ore producers. Brazil’s largest exports to China are soybeans and iron ore. However, there is a risk that a global economic slowdown could adversely affect steel demand.

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Inflation, Inflation, Inflation

Inflation, we have been talking about, the market has been talking about it, but has the Fed? In short the answer is yes, but it appears the market may not think so. For the first time since its introduction in 1997, the 5-year TIP traded at a negative yield, implying a significant lack of confidence in the Fed's ability to fight inflation. The market is essentially betting that the Fed has lost sight of inflation and is solely targeting growth. We do not agree with the market's assessment. First off, lets rehash an early blog post titled 'Fed Cuts & Inflation' :

"So long as the Fed considers downside risk to growth exists we can expect that rate cuts will remain on the table as long as Core PCE remains below the 2.7% to 3.0% range, or growth conditions do not deteriorate more significantly."

To be more specific, so long as demand continues to be a drag on growth and inflation remains within a 'comfortable' level, the Fed will cut rates. However, if inflation exceeds the Fed's comfort level (as defined above), then we would likely see a quick reversal of policy, or at least the end to rate cuts. Core PCE for January finished 2.18%y/y vs 2.23%y/y the month prior. The Fed has not forgotten their dual mandate. The Fed realizes inflation is trending up, and it is clear that in addition to rate cuts they are looking for alternative methods to alleviate the credit crisis.

With this in mind, to us today's Fed announcement implies a smaller rate cut at their official meeting on March 18^th. We were originally calling for a rate cut of 75bp, but this move, pending how the market reacts over the coming days, changes our forecast to 50bp (with 25bp being a possibility). Of course the relationship between further easing and inflation wasn't the only topic on the Fed's mind in making this decision, but it was probably a factor. The bottom line is the Fed is well aware of inflation and will act accordingly. Markets can only trade irrationally for a finite period of time.

Now What? The Week Ahead

Last week’s performance was pretty much in-line with our expectations, as outlined in our March 2^nd post. But what’s going to happen this week? The beginning of this week is going to be relatively quiet on the data front. However, we will be ending the week with some important consumer related data including CPI, Retail Sales, and Consumer Sentiment (See calendar below).

Nevertheless, the main question this week will be whether or not the Fed cuts rates before the March 18^th meeting and if so by how much. First the easier question, we anticipate the cut will be 75bp. Now the harder one, we think that we are close enough to the March 18^th meeting for the Fed to wait. However, this will be very market dependent. If the market experiences a significant sell-off, then we are likely to see the Fed to act early. Typically, when the Fed delivers unexpected news (such as a rate cut) it usually occurs between 8:15AM and 8:30AM, so please be on the lookout if this scenario does plays out.

If you believe, like us, the Fed would intervene to stem any significant sell-off, then this week could turn into a good buying opportunity. Essentially, the potential Fed rate cut would work as a partial hedge against market risk, not a bad deal. The Fed has a tendency of not disappointing market expectations, and this will not change in the short-term, especially now. So if the market does experience a significant sell-off we would expect the Fed to act (as they did on Jan. 22^nd) and potentially generate at least a short-term rally (See chart below for SP500 performance during the Jan. 22^nd cut). At the same time, if the market does not experience a sell-off, the increased likelihood of a 75bp cut at the next Fed meeting should help bolster market performance.

S&P500 performance during Jan. 22nd inter-meeting rate cut

Market performance will remain very dependent on news from the financial industry and economic data releases. Here are the economic releases that could affect the market this week:

Monday March 10th:
None

Tuesday March 11th:
8:30AM: International Trade (Risk: Neutral)- According to Bloomberg.com the market is currently expecting a trade deficit of USD59.5bn vs. USD58.8bn last month.

Wednesday March 12th:
None

Thursday March 13th: Key Day in a Quiet Week
8:30AM: Retail Sales (Risk: Slight Upside)- According to the consensus survey Retail sales are expected to increase 0.2% M/M for both the headline and core reading. There could be some upside to this release from better than expected sales figures for discount retailers such as Wal-Mart

8:30AM: Import Prices (Risk: Slight Downside)- Bloomberg.com currently states a market consensus of +0.6% M/M change in import prices. Increased commodity and food prices will continue to put pressure on import prices. The big concern is how strong the pass-through effect will be to the overall CPI.

8:30AM: Jobless Claims (Risk: Downside)- Bloomberg.com currently states the market is expecting a reading of 358K. We find this to be one of the most important indicators for the health of labor market. Given continues weakness in the labor market, and signs that the commercial construction industry may be on the verge of slowing; we believe this number has the potential to surprise to the upside. Basically, any reading below 350K is considered relatively healthy, and above could warn of a recession. The 4wk moving average currently stands at 359,500. Non-farm payrolls tend to be a lagging indicator of overall economic health, while jobless claims tend to be a leading indicator, hence its importance.

10:00AM: January’s Business Inventories (Risk: Neutral)- The consensus survey expects business inventories to increase 0.5% M/M.

Friday March 14th:
8:30AM: Consumer Price Index (Risk: Neutral/Slight Downside)- The consensus survey is expecting a 0.3% and 0.2% M/M increase in CPI and Core CPI, respectively. Growing food prices, high commodity prices, and a weak dollar will continue putting upward pressure on CPI. However, how much of this will be nullified by decreased demand is yet to be seen. For more on the importance of inflation and Fed Cuts please see our Feb. 27^th posting (http://fiateconomics.blogspot.com/2008/02/fed-cuts-inflation.html).

10:00AM: Consumer Sentiment (Risk: Downside)- The market is currently expecting a reading of 69.5 after experiencing a free fall last month to 69.6. Given last month’s drop it is hard to make an accurate measurement, but we believe it is likely to come in below current expectations.

*Investment Idea:

We believe the fact that the Fed has always delivered news of inter-meeting rate changes to the market at around 8:15AM EST can be used to our advantage. Take this for example, if the market experiences a significant sell-off and an inter-meeting cut seems likely, you could purchase futures on U.S. Indices just prior to the 8:15AM EST expected announcement. If the cut does occur, then we should see a rally in future prices, and the position could be unwound within 15 minutes. If a rate cut does not occur, the position could be sold within a very short time frame helping to minimize any losses. Since you are only holding the position for a short period of time downside risk should be relatively mild, while potential upside if the cut does occur could be significant. However, you could face other risks such as negative company or sector news being released while you are holding the position. This notwithstanding, if this scenario comes about we believe the risk is worth the potential short-term gain.

*There is substantial risk in trading futures, so please make sure you know what you are doing! Also, this is an investment idea not advice so trade at your risk.

Chinese Inflation: A Mounting Problem

I was asked my views on the Chinese inflation situation today and came up with this short piece:

The Chinese growth story is now sharing the spotlight with the country’s mounting inflation concerns. In January consumer prices rose 7.1%y/y; to a level not seen since 1996, a point when China was in the midst of recovering from levels around 20%y/y. Moreover, based on the current outlook February’s reading is not expected to show any signs of improvement. Starting late January and ending in February China faced a barrage of disastrous winter weather, affecting nearly every aspect of the economy, including crops. This is particularly relevant given that food prices have been the main cause of Chinese inflation, increasing an astonishing 18.2%y/y in January. Important to keep in mind is that January’s reading includes only a small portion of the storm’s total effect, which will be fully reflected in February’s release.

Drilling a bit deeper into China’s inflation problem we look at some of the reasons for the increase in food prices. In part this trend can be attributed to China’s economic success; Chinese economic growth has led to an increase in wealth among its population. With more money to spend Chinese citizens tastes began to shift, in the food sector this meant instead of having vegetables for dinner they preferred meat, especially pork. Since demand for these ‘new’ products are rising faster than they can be supplied, prices are going up. Despite the simplicity of this explanation it could have a significant effect on the Chinese economy. Take this scenario into account; if you expect dinner is going to cost more next month than it did today you are going to ask for better wages to make up the difference. With this in mind inflation expectations have a direct correlation with future inflation based on this principle. Currently, we believe this scenario may already be occurring. Price increases are now showing up in sectors other than food, including services, producer prices, and other non-food products. The increase in service prices could very well imply we are already seeing an increase in the cost of labor due to rising inflation expectations. This scenario will have to be watched closely by Chinese policy makers.

Curtailing the inflation problem will be a tough challenge for Chinese leaders, especially given an increase to inflation expectations. In a more traditional scenario, the solution would simply be a combination of tight monetary policy and conservative fiscal policies. However, a number of problems including reconstruction plans from the winter storms, ‘quasi’ pegged exchange rate, and liquidity factors add up to a unique challenge. Reducing government spending at a time when a large portion of the country’s infrastructure needs to be repaired is not feasible. Additionally, further appreciation of the RMB could reduce exporters’ price advantages to overseas competitors and may reduce Chinese market share lowering economic growth. Finally, increasing rates could make it harder for businesses to borrow within China during a time of industry consolidation; potentially adversely affecting growth. A likely outcome will come by finding a balance between tighter monetary policy and further appreciation in the RMB.

Fed Cuts & Inflation

*Sorry for the delay in posting we were experiencing serious computer issues

One of the questions on everybodys’ minds is how high would inflation need to go before the Fed would reconsider any further rate cuts. During the recent months’ we have seen increasing down side risks to the US growth forecast, while at the same time growing inflation expectations. This is a dangerous mix in terms of continuing to use Fed policy as a stimulus to the economy. Historically, looking back at the data (since 1995), we can see that the Fed has never lowered rates when the Core CPI has gone above 2.9%, this means we could have at some room left, before the Fed rates cuts could potentially come off the table. To further test this we applied an ordered probit model with a grouping of economic indicators (ISM, core PCE – 2.0% inflation target, & a 1 month lag in the change in initial claims - 350) to see how the current situation compares to those in the past and to see which way the Fed is likely to move and in what magnitude based on inflation rates. What we discovered after running the model for both Core CPI and Core PCE (which we see as the Fed’s indicator of choice) was in-line with our original estimation that for the Fed to reconsider the cuts we would need to see the Core rates move to between 2.7% & 3.0%. Currently, the Core PCE and Core CPI are at 2.2% and 2.5%, respectively, with expectations rising.

To quantify the rate change we created five categories ranging from –2 to 2, with 0 implying no change. We created these categories after individually analyzing all FOMC rate changes from 1995 until 2007. To quantify the change we categorized the magnitude of the Fed rate hikes or cuts at each individual meeting into three groups: 0, 0.25%, and =>0.50%. So for example, a rate hike of 0.50% points would lead to a score of 2, while a rate cut of 0.25% would equal a score of -2.

With the left-hand side variable defined this way we ran them using an ordered Probit model against the ISM, inflation gap, and initial claims. We found that all of the variables were statistically significant.

The results show that the implied Fed rate change currently stands at -0.03 on our scale of -2 to 2, and has decreased in intensity over the last two months from its interim low of 0.09 in June (Chart 1). This movement corresponds to the decreasing growth and wavering employment levels. The current reading shows that there is a downward Fed bias, which implies the Fed is more likely to lower rates rather than raise them…

Conclusion:

So long as the Fed considers downside risk to growth exists we can expect that rate cuts will remain on the table as long as Core PCE remains below the 2.7% to 3.0% range, or growth conditions do not deteriorate more significantly.

Fed likely to go 50 (Another look at China, India, Las Vegas Sands, and an introduction to Taiwan)

This mornings GDP reading of +0.6% will outweigh the positive ADP number and lead to an additional cut of 50bps at today's meeting. However, if the Fed were to cut by only 25bps we would expect a large sell-off in the US and global EQ markets; leading to in our opinion to another good buying opportunity. Fundamental economic data in the US is still not pointing towards a US recession, but both the EQ and FI markets continue to price one in. Our view is that the housing problem continues to be just that, a housing problem. We would need to see a clear spill-over into consumption before we began to worry. Keep in mind housing wealth is only a small component of consumption, with financial wealth and income making up the rest. Financial wealth and housing wealth tend to have a lagged and marginal effect on consumption verses income whose effect is both strong and immediate. Meaning, so long as we continue to see good employment (claims below 350K, etc..) and growing income levels we do not expect to see a recession. The way we see it is that we are still in the midst of a good buying opportunity and remain bullish on China, India, and Las Vegas Sands.

As an aside, we are now looking into the Taiwanese EQ market. The recent parliamentary elections in Taiwan provided the China 'friendly' party with a landslide victory; a result which is likely to follow in the March 22nd Presidential elections. Once the new administration takes power they will likely strengthen ties with China and Taiwan will begin to share in China's economic success, from which it has remained mostly isolated. To take advantage of this market we are looking into the ETF 'EWT', which attempts to track the braod Taiwan EQ market.