Letter From Shanghai No 910 - Consumption Delayed

The Fed leaned into its inflation problem by raising policy rates by 75 bps to 1.50-1.75% last night. However, the “dot-plot” was more telling, indicating an expectation that rates will climb to 3.4% by year-end. My assertion that year-end US rates will be around 4.5% below the December inflation rate still looks safe for now. However, as there are four further Fed meetings in 2022, it would seem we will have a 50 bps move in each one, or perhaps they will front-load the first 3 meetings with at least one more 75 bps rise.

In data released yesterday, Japan pared its holding of US Treasury bonds in April from USD 1.232 trillion to USD 1.218 trillion, which would suggest a continuing need to buy the domestic bond market in Yen to maintain its increasingly out-of-step QE policy. The falling yen has stabilized, for the moment, around 134.20, as a finance ministry official told Reuters that authorities “won’t rule out currency intervention, or any other available options.” However, some observers feel a lower and more competitive Yen would be a problem for Beijing and its GDP target of 5.5% this year.

China also lowered its holdings of US Treasury bonds by more than $36.2 billion, taking the total holdings down to USD 1.003 trillion, the lowest level since May 2010. Domestic commentary would suggest that this is a good thing, arguing China should increase its investment in strategic resource-producing countries and “open up” and increase the amount of yuan settlement and yuan pricing power when trading with other nations.

Domestically it is difficult to be excited. The aluminium stock fraud, which emerged in early June when Ping An Trading Co. Ltd found it had been misled into providing financing for more than 30,000 tonnes of aluminium ingots, an investment worth RMB 600m. In reality, much of the inventory did not exist or had been mortgaged several times. Accepting ownership documents as collateral is a major lynchpin of commodities trading, therefore to mortgage a non-existent or the same parcel several times is fraud. It is not a complex fraud but requires several well-placed and coordinated participants. In my example, a trader will offer his stock as collateral and, at the right terms, the lender is happy to lend and will check with the warehouse that he, the lender, is now the sole owner of the material as collateral. The warehouse routinely confirms the stock is on the premises and the lender is now the sole owner. However, the borrower goes out again and borrows additional money against the same parcel and the warehouse fraudulently confirms to the new lender that he is the sole owner. Therefore, as the trader and the warehouse have acted fraudulently, two unconnected lenders believe that they are the sole owner of what is the same commodity as their loan collateral.

The situation in China points to 3 individuals and the companies controlled by them, as well as several co-conspirators in warehouses located in Foshan, Zhejiang, Ningbo and Shanghai. Beyond that, dozens of senior companies with SOE-type backgrounds as lenders may have lost a considerable amount involving billions in payments. One would expect, as the fraud may have started four to five years ago, the fraudulent ownership documents could have now seeped into the trading mainstream, therefore, ensnaring companies that have no fraudulent intent. Suffice it to say the entire physical base metal market is frozen as traders and banks inspect inventories and try to establish the veracity of their ownership documents. Where is the money and who owns what are only two of the issues facing the courts. I would suggest most companies, even those tangentially affected, will try to definitively establish their position for their end-of-June management accounts. In such an atmosphere, nobody can have any intention to trade as confidence regarding counterparty risk is badly compromised. Combined with the lower-than-expected economic activity post Shanghai's reopening, some observers may conclude that support for base metals prices driven by Chinese consumption will, for the moment, be delayed.

Have a good day,

John