The Chinese Bag of Tricks

Overnight, Chinese exports have just become a lot cheaper. Why would China devalue their currency to make their goods less expensive? It’s a bet that China’s goods will be more competitive in the global market, and their economy will benefit in response. But now, this event adds to the uncertainty of whether the Fed will hike rates in September.

World stocks, Asian currencies, commodities and government bond yields all headed south after the China devaluation of the yuan last week, further triggering concerns over the country's economic health. We have been re-porting for weeks of China’s magic tricks to prop their numbers and markets, so it is no surprise that currency devaluation was the next act to come out of the Chinese bag of tricks.

Tuesday, China magically devalued the yuan 2% against the dollar, and then Wednesday set the yuan daily midpoint reference at 6.3306, pushing the currency down 4% from Monday’s close. The week closed, shaking out a reference rate of 6.3975 per dollar, down 3% from the original peg. Beyond arresting short sellers, the Chinese government has used a state-owned company, called China Securities Finance Corp, to underwrite the margin lending activity of certain brokerages. This Chinese government-owned entity has become a top-10 shareholder in a large portion of Chinese markets, which is eerily similar to the TARP bailouts. Devaluing its currency is also not much different from our very own QE program. No matter how you look at it, stimulus is essentially money printing in different ways.

With America buying $466 billion of goods from China and selling $123 billion of goods to China in 2014, with the 3% devaluation of currency, Americans just put $17,713,118,555 in their pockets. Think about that; the American economy just became almost $18 billion richer in less than a week, and Chinese manufactures and consumers just got $18 billion poorer.

Not to open old wounds, but think back to 2006 and 2007 and the reliance the US had on the housing market to support the domestic economy. The export sector in China is what the housing market was to the United States before the party ended, and the house of cards came tumbling down. The communist party has already pulled about every trick possible to prevent a full meltdown of their equity market, but they know that the base card that is holding up their house of cards is the manufacturing sector, just as our government sprang into action to prop up the American financial industry.

The devaluation of the yuan puts a 3% hurt on the Chinese people, but their government is betting that because their goods are less ex-pensive, they will become more competitive. Another motive could be that China wants the yuan to become the world’s reserve currency and letting the currency float is a major step in that direction. However, at the end of the day, devaluing their currency is just another trick by the Chinese communist party to prop the economy and give the manufacturing sector a fighting chance to come close to their overinflated GDP numbers.

The focus that we have been publishing for weeks is what the Fed is going to do with rates. The Fed has been targeting a 2% inflation number to raise rates, and this move by China further pushes down inflation. The argument has been in place since the recession — how can we be inflating when prices of everything from housing to oil to Chinese trinkets sold at Wal-Mart are going down?

Based on what the market is pricing in the forward curve, it looks like the Fed is still aiming for a rate hike in September, and we feel that the domestic and world economy is just not ready to digest it, no matter how small the hike is. Low commodities are actually good for the American and the world economy. Cheap oil and commodities make it possible for the Chinese to lower costs and invest in plants and equipment. To put the currency devaluation in perspective, think of China as a factory that just passed cost savings on to their customers, because their suppliers just lowered their costs. A Fed hike could unwind everything that the Chinese are trying to accomplish; all it will take is a short-term hiccup to derail what has been, and will continue to be, a very long road to recovery when the American house of cards comes tumbling down.

So, is China’s bag of tricks empty, and will America’s next trick be a rate hike in September?

The above article is an excerpt from EQS Trading’s Weekly Publication on the Commodity Markets called “Signals” which we write and publish every Monday. EQS Trading also publishes a daily “Trade Signals” email that provides in-depth “short” and “long” recommendations and trade strategies for the commodity market with entry prices and stop loss levels.

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