How to Profit from China's Next Move

Data released yesterday showed that the US posted a budget deficit for a record 18th straight month. The budget gap was $65.4 billion last month, which was wider than the $62 billion figure predicted by most economists. The data proves we are still on path to reach a record $1.6 trillion shortfall this fiscal year. The only good news from the report is that revenues were slightly higher than a year ago, but the problem is that government spending continues to outpace any increase on the revenue side.

If the deficit ends up coming in right where the administration predicts (it will likely be even higher), the $1.6 trillion would represent 10.6% of the US Gross Domestic Product. This would be the largest deficit as a percentage of GDP that the US has run since World War II.

The growing deficits will eventually drive Treasury yields higher, as our government continues to flood the market with US debt. But for now, global investors continue to eat what we are cooking, so the markets pretty much ignored the report. The stock market rose above the important psychological level of 11,000 and the 10-year treasury moved higher also moving yields down below 3.85%.

Today we will get a report that will probably show the trade deficit increased to $38.5 billion from $37 billion the month before. We will also get a report that will reflect import prices and the ABC consumer confidence numbers. I don’t expect any of this data to ‘move the markets’, as most traders will be focusing on a plethora of data to be released here tomorrow. Wednesday is shaping up to be a big day for data with the release of the CPI numbers for March along with Advance Retail Sales, Business Inventories, and the Fed’s Beige book.

The leaders of the BRIC nations will hold a two-day summit in Brazil later this week. This is the second annual meeting of these emerging market powerhouses. Readers will remember that last year the summit produced calls by these BRIC nations for the establishment of a new global reserve currency to replace the dollar. I would look for renewed calls for the move away from the buck as these countries start to ‘feel their oats.’ Russian President Dmitry Medvedev called for greater trade cooperation between these countries and pushed for increasing trade in their own currencies, avoiding the use of the US dollar. Brazil and China agreed to a major commodity sale last year using their local currencies instead of the dollar. Contracts like these will continue to eat away at the reserve status of the US dollar.

Growth in these nations continues to dramatically outrun growth in the more established economies; and more importantly, debt levels in these nations are actually shrinking, while debt levels in the US, UK, and most of Europe continue to expand.

The news wires continue to suggest China will let their currency rise sometime in the next three months. This timetable is a result of Treasury Secretary Tim Geithner’s delay in the release of a report that all but guaranteed China being labeled a currency manipulator. The delay assured Chinese President Hu Jintao’s attendance at the two-day nuclear security summit being hosted by Geithner’s boss, President Obama. The two Presidents met today in Washington, and the topic of the renminbi’s value was top on the agenda.

Both sides were reluctant to give details of the talks so I am fairly certain neither side budged. I imagine Obama told Jintao that the Chinese should let their currency appreciate, and Jintao reminded Obama that the Chinese hold quite a bit of US debt, and Congress better be careful of what they are demanding. If the Chinese do decide to let their currency rise in value, they would have less reason to continue purchasing US debt.

Most of Wall Street now expects China to let their currency start floating again in the next few months. Many are expecting a one-time adjustment of 2 to 5% followed by a resumption of their slow and steady move higher. We saw a similar occurrence back in 2005 when the Chinese first released their currency from a peg to the dollar. But is a one-time 2% adjustment followed by slow but steady appreciation really going to satisfy the US congress? After all, we have seen the euro (EUR) move more than 2% versus the US dollar in the past two days!

And what is the risk to investors rushing into the Chinese currency? Well, many believe the Chinese economy is currently in a classic bubble. The government has encouraged real estate development and infrastructure growth in order to keep their economy from slowing down. I was discussing China with a very astute WorldMarkets investor who was deciding on the timing of a million-dollar purchase of the Chinese renminbi (CNY) the other day. We discussed the current state of the Chinese economy, and I told him how I believe they will continue to be the growth engine of the global economy. He reminded me of a very similar story back in the 1980s and ’90s when everyone was excited about the emergence of Japan as a global economic power. I remember studying the ‘Japanese’ way of doing business, and hearing professors tell us how Japan could really do no wrong. Japan continues to be a global power, but countries are no longer looking to copy their policies.

So should investors be rushing to buy Chinese renminbi in order to take advantage of this possible appreciation? I don’t think there is a lot of risk in owning the Chinese currency at this point, but there are probably better ways to benefit from a new float of the renminbi. The last time China relaxed the trading range of their currency versus the US dollar, other Asian currencies also moved higher. And most actually outperformed the renminbi versus the dollar. The Hong Kong dollar is probably the most obvious currency investment alternative to the renminbi. Many believe the Chinese will ‘try out’ any revaluation of the renminbi by first allowing the Hong Kong dollar to adjust higher.

The Singapore dollar (SGD) is, in my opinion, another excellent way to profit from any potential rise in the Chinese renminbi. Singapore has to compete with China, and has tried to keep their currency in line with the renminbi. But the government of Singapore has recently announced their intention to let their currency appreciate.

Unlike most other central banks, Singapore’s does not use interest rates to control inflation in their economy. Instead, the central bank combats rising prices with adjustments to the value of the Singapore dollar. Recent data show inflation is starting to heat up, and the government recently informed the markets that they would allow their currency’s value to move higher. If China would allow an appreciation of the renminbi, Singapore would be emboldened to allow an even faster appreciation of the Singapore dollar. Since the Singapore dollar is not constrained by ‘trading bands’, it could give investors a better return than just sitting in the Chinese renminbi.

The BRIC nations dominated the newswires over the past few days, and I am going to devote the majority of today’s Pfennig to them. Brazil’s real (BRL) was the top performing currency versus the US dollar over 2009, but it has taken a step back during the first quarter of 2010. But with a growing economy and rising commodity prices pushing inflation higher, the Brazilian central bank will likely be forced to raise interest rates at its next policy meeting April 28th. Brazil’s interest rates are some of the highest in the world, and investors like these yield differentials.

I read a research report last night that suggested the Brazilian real would appreciate over 10% after the central bank moves rates higher. Carry trade investors have to be licking their chops at the yield differentials available in Brazil and with the US FOMC keeping rates low for an extended period, risks to the carry trade seem limited. As one research report stated, “How can you short a currency with an interest rate close to double digits when the economy is on track to grow and the stock market is booming?” Brazil continues to look like a good position for the ‘riskier’ portion of your investment portfolios.

I will close out today’s Pfennig with a message from Chuck:

Folks… And dear readers… I’ve suffered a setback in my recovery from cancer. The mass that was found on the back of my left eye over a year ago, that was shrinking, began growing again and has gotten to the size that it has caused incredible pain that has caused me to keep both eyes closed for long periods of time. I have some medicine to combat the pain, but it makes me sleepy, and since my eyes are closed, I fall asleep all the time.

I had total body scans on Friday and will find out the results of them this afternoon. I do not know any more than that at this time. I can’t seem to catch a break these past two weeks either, as my back locked up on me when I tried to get off the bone scan table last Friday… UGH!

I’m sorry that you’ve not heard from me… I really could not focus long enough to type something out until now. I’ll be back later this week with the outcome and plan of attack…

Thank you dear reader, you are an inspiration to me to continue fighting…

I know I speak for everyone on the trade desk and probably for most readers in saying that Chuck has it backwards; he is a tremendous inspiration to all of us and not vice versa! I have been absolutely amazed at how he fought his first couple of rounds with this horrible disease, and will continue placing my wagers with him. I just know he will beat it again, and be back in the saddle before long. But I also know he appreciates all of your words of encouragement and please keep him in your thoughts and prayers.

Chris Gaffney
for The Daily Reckoning