China Weighs-In on the European Debt Crisis

We had a busy day on the desk yesterday, but not because of volatility in the markets. The dollar traded in a very tight range versus all of the major currencies yesterday, and is still in that same range as I flip the screens on, this morning. There aren’t any meaningful data releases in the US this morning, and the trading desks are starting to get squared up for the holidays; so I would expect today’s markets to be more of the same.

The debt crisis in Europe is still dominating the news wires with questions continuing about the health of the Irish banking system as Moody’s Investors Service cut its ratings on several major Irish banks. The cut for the banks’ ratings comes just days after Moody’s dramatically reduced Ireland’s overall rating. Ironically, the rating agency referred to its own dramatic cut as one of the main reasons it was downgrading its ratings on Ireland’s largest banks. Neither Chuck nor I are big fans of these ratings agencies, and I wonder if anyone really trusts them after the MBS ratings fiasco that helped spark the US financial crisis. I have found that the ratings agencies are typically late to the game and simply “pile on” after the fact, seldom uncovering any new facts or findings. I appreciate the fact the Irish banks are probably going to need some extra liquidity, as the debt crisis has caused an outflow of funds. But this was apparent months ago, and the Irish government has already agreed to accept support from both the EU and IMF.

Ireland has adopted a fairly aggressive plan to deal with the crisis, and austerity measures have already started to take hold. Don’t get me wrong, the crisis in Ireland is far from over, but as usual, Moody’s is a bit late to the game. Late yesterday, the folks over at Moody’s shot another round off at the euro when they put Portugal’s credit rating on review for a possible downgrade. I guess Moody’s feels their job is done in Ireland, and want to move on to the remaining two countries of Portugal and Spain.

It almost feels like the whole European debt crisis is following a very organized script. It began with Greece, then moved on to Ireland, and will now end with Portugal and then Spain. Italy has been attacked off and on during all of this, but overall the crisis has played out in a very organized fashion. Shouldn’t all of the countries been downgraded at the beginning of the crisis? From day one, everyone knew that the problems in Greece were also being felt in Portugal, Ireland, and Spain. It just feels like this whole crisis is just too darn organized.

The euro (EUR) would typically have been sold off with the ratings downgrades, but Chinese Vice Premier Wan Qishan rode in on a white horse to keep the single currency from falling too sharply. Qishan said the Chinese would take “concrete action” to help the European Union with its debt problems. I’m sure these actions will include direct purchases of debt by the Chinese and a shift toward the holding of more euros in their massive currency reserves.

China has good reasons to try and maintain a strong EU, as the EU has been China’s biggest trading partner for six years. China is also the second-most important buyer of EU exports, so the two regions certainly have a lot at stake.

The euro was also helped by data showing that German consumer confidence is remaining near a three-year high. German households are increasing spending as employment continues to creep back up. German companies have been hiring back workers in order to meet global demand. Unemployment fell for a 17th month in November, and retailers say they are having a better-than-expected holiday season. Consumer sentiment is good, and the German economy certainly looks like it will continue on a recovery path.

What does all of this mean for investors? Well, first of all, I think the Chinese support is another sign that the euro is here to stay. Those that are calling for a breakup of the euro will, in my opinion, be proven wrong. But the debt questions will continue, and will probably keep a lid on the appreciation prospects of the euro. Those with a shorter-term outlook should probably have already sold euros, but I have a longer horizon, and the euro will remain as one of the “base” currencies in my personal portfolio.

Another currency that I think makes a good “base” holding for currency allocations is the Swiss franc (CHF). Obviously, the franc is very dependent on the overall European economy. But the Swiss also has the benefit of being outside of the single currency. Worried investors have been shifting out of the euro and buying Swiss francs, which reached a record versus the euro for a fifth consecutive day. This appreciation of the franc has started to take a toll on Swiss exports, which declined in November. The Swiss National Bank has attempted to hold down the appreciation of the franc, but as Chuck pointed out the other day, central bank intervention can’t reverse the market. At best, intervention can change short-term sentiment and can weaken currency movements, but over the long term, the fundamentals will carry a currency. The Swiss economy seems to be fairly resilient, as inflation has been dropping and employment has ticked up. The Swiss continue to have a trade surplus of just under 2 billion Swiss francs; another good sign for the economy.

While German and Swiss consumers are increasingly confident, the feeling is a bit less optimistic in the UK. Upcoming spending cuts that will be implemented by the UK government in the coming year have the UK consumers in a rather dull mood. UK spending in November rose the most since February, but the increased spending was accompanied by an even larger increase in borrowings. UK Prime Minister David Cameron has announced a plan that includes the deepest spending cuts for the UK government since World War II, so this latest boost in spending/borrowing may prove to be a last gasp for the UK consumers. The proposed government spending cuts will be accompanied by fairly large tax increases, so the near-term future for the UK consumer isn’t all that positive.

The vote of confidence that the Chinese gave the euro appeased the worries throughout the currency markets and investors began to move back into the higher yielding currencies. With China throwing their support behind the euro, risk trades moved back into vogue. The Australian dollar (AUD) is approaching parity versus the US dollar again, as investors gain confidence in the Asian recovery. China’s demand for raw materials, especially copper, coal, and iron mined in Australia, should keep the Aussie dollar well bid going forward. Commodity price inflation may force the Reserve Bank of Australia to raise rates more quickly than what the markets are expecting.

The New Zealand dollar (NZD) also rose in spite of what is expected to be a poor third quarter GDP number. The figures will be released tomorrow, and are expected to show that the New Zealand economy has stalled a bit, growing just 0.1% in the third quarter. This is not good news for investors in the kiwi, as the slower growth will probably keep Alan Bollard from raising interest rates until the latter part of 2011.

The Chinese government announced that they expect Chinese inflation to be 3.3% in 2010. Policymakers continue to try and combat rising inflation, which reached a 28-month high in November. Officials have raised reserve requirements for banks and have pledged price controls if necessary. Another possible tool they could use to slow internal price appreciation would be to let the renminbi rise at a faster pace, but this is apparently not one of the tools they plan on using. Chinese Prime Minister Hu Jintao will visit Washington next month to meet with President Obama. I’m sure the value of the renminbi will be front and center on the agenda. The Chinese renminbi (CNY) has typically strengthened just prior to previous meetings between the two leaders, so we could definitely see another move by the renminbi over the next few weeks.

Gold has rallied over the past few days and is trading just over $1,386 this morning (up about $16 in the past two days). Investors continue to pour money into the gold and silver ETFs, and that increased demand is giving support to the precious metals prices. Gold will end the year with close to a 27% gain, which would be the 10th consecutive year with positive results. With the unstable global economic recovery, and questions swirling over sovereign debt, it would seem 2011 will likely be another positive year for the precious metals.

As I said during the opening of today’s Pfennig, we don’t have any real data releases today, so I would expect it to be a relatively quiet day for the markets.

Chris Gaffney
for The Daily Reckoning