Here's What the Shanghai Accord Means for the Dollar

The Shanghai Accord in its simplest form is a weaker dollar, a weaker dollar for imported inflation, a weaker dollar to stimulate U.S. exports (as noted previously here). It was a way for China to cheapen their currency without breaking the peg to the dollar.

You would cheapen the dollar, and then China would keep the peg, and the Chinese yuan would cheapen along with it. That framework came out at the end of February, and it was a very good guide for policy from February through June or July.

The problem is, and this is really important to understand, all of these processes are dynamic, and a lot of them are in conflict. In other words, the central banks want things that conflict with each other.

For example, the Federal Reserve (Fed) wants inflation. They say so. It’s not a secret. One of the ways to get inflation is a cheaper currency, but they also want to raise rates. Which is why they have to raise rates, so they can cut them in the next recession.

Raising rates makes the dollar stronger. How do you reconcile a weaker dollar, which imports inflation, with a stronger dollar, which creates deflation? You can’t. They’re completely opposite goals, but this is where the approach diverges.

The central banks, because they’ve spent 8 years manipulating markets, manipulating the yield curve, manipulating exchange rates, fighting the currency wars, etc., have painted themselves into a corner from which there is no escape.

It’s very important to understand you can’t just take one idea and put a stake in the ground and say, “That’s my idea for the next 2 years.” That doesn’t work.

We must act ahead of the curve. We offer much better analysis than Wall Street. We update continually. We’re the first ones to say, “Hey, circumstances change. People change. Administrations change. We’re going to look at the new updates, and we will amend the forecast.”

The big picture for the Shanghai Accord is that a weaker dollar is still out there, but the Fed will temporarily say they can get away with it.

It’s like a little child trying to steal money from their mother’s wallet. If they think they can get away with it, they will. What they’ve been doing for years is looking for a way to get away with a rate hike. Mostly, they couldn’t do it because, as the Fed did last December, it raised rates – and the markets fell apart.

Now, the Fed thinks the coast is clear. They think mom’s not looking. They’re going to go steal another dollar out of the wallet, and they’re going to raise rates in December.

That is contrary to the Shanghai Accord, but the big idea of the Shanghai Accord is that you need to keep a peg with China and the weakening dollar is still in play.  Though I would say it’s in hibernation right now. We are going to see this rate hike, and we’re seeing it in the stronger dollar coming.

What’s interesting is that, and this is where the dynamic analysis comes in, what was the point of the Shanghai Accord? The point of the Shanghai Accord to see if it was possible to cheapen the Chinese currency without breaking the peg to the dollar? The answer is yes, if you cheapen the dollar. Right now, we’re not getting a cheaper dollar because the Fed’s going to raise rates. For the big picture of cheapening the yuan is still in play.

What does that mean? It means that you’re going to cheapen the Chinese currency and break the peg, and that’s exactly what’s happening.

If you look at the Chinese currency, they are sinking like a stone against the dollar. What’s different between now and August 2015 and December 2015 is that the markets don’t notice. The markets have not reacted to a weaker yuan the way they did the last two times.

This is a bunch of central banks walking on eggshells, trying to escape, hoping people don’t notice. It’s a lot to process because everyone’s got their little corner or their little box or their little slice or whatever it might be. You got to step back from that to look at the big picture.

This creates even more vulnerability for stock markets. In other words, people haven’t really focused on the Chinese yuan. What if they do? What if they wake up and say, “Wait a second. See what the Chinese are up to?”

Meanwhile, the dollar’s getting stronger. Rates are going up. The Chinese are weakening. What does that mean for capital flight in China? What does that mean for Chinese stability? As this story evolves, you just have to stay vigilant.

Regards,

Jim Rickards
for The Daily Reckoning

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