Traders Fear Chinese 'Bubbles'

The big story on the screens this morning comes to us from China where inflation has reached a 16 month high. These dramatic headlines have sent currency investors heading back to the Japanese yen and US$ as many of these stories suggest the Chinese will be stepping in to slow the Chinese economy. But if you look beyond the ‘16 month high’ headlines, you will find that consumer prices rose just 2.7% in February from a year earlier, and increase yes, but hardly the stuff of a ‘bubble economy’. Premier Wen Jiabo has stated a goal of keeping inflation around 3%, so the inflation number is still below his goal. And the Chinese have already started pulling liquidity out of the Chinese banking system with increases in the reserve requirements and internal interest rates.

Another worry for me, is the Chinese production numbers, which showed a 20.7% increase in the first two months of 2010. These production numbers make it likely we will see another double digit growth number for China in the first quarter of 2010, following a 10.7% gain in the last quarter. These are impressive numbers, and I see where some would believe the Chinese economy is nothing but an ever increasing bubble. Another bubble which worries many investors is the Chinese property market, where prices in China’s 70 largest cities rose by 10.7% according to China’s statistics bureau. But much of this growth has come in a few booming cities, and commercial property values have been subdued and are actually starting to fall.

The Chinese have done a good job of managing their economy thus far, and while some of their growth numbers are worrisome, I don’t see them ‘slamming’ on the brakes anytime soon. Officials have introduced policies to try to rein in soaring property prices, and have raised the down payment requirements to avoid a western style mortgage meltdown. The Chinese economy will continue to be the driving force of global growth over the next decade, and they will continue to demand more raw materials to support their growth.

As Chuck predicted yesterday morning, the New Zealand central bank left rates unchanged. Chuck used to have an inside track to New Zealand central bank policy, as he had the direct line to Don Brash who was the Reserve Bank governor for 14 years. The new Reserve Bank Governor, Alan Bollard, hinted that interest rates would remain stable for the near future. “We continue to expect to begin removing policy stimulus around the middle of 2010.” Bollard said after leaving the official cash rate unchanged.

Bollard’s dovish talk caused the kiwi to lose a little ground vs. the US$, and a bit more vs. the Aussie $. Currency traders had priced in rate increases beginning in June and continuing through the end of 2010, but yesterday’s communication had them backing away from these predictions. Bollard said the economy is in a ‘relatively sluggish’ recovery, and recent data suggest the New Zealand economic recovery is a bit shaky. House prices fell in January, and credit card spending has steadily declined in 2010.

But the New Zealand economy is still on the growth track, and with China continuing to hold up commodity prices, the kiwi should be able to hold on to recent gains. Last year, Japanese investors looking to lock in higher yields helped propel the kiwi to a 25% return vs. the US$. Even if the next interest rate increase in New Zealand is pushed off a month or two, yield differentials should keep the kiwi looking like an attractive investment alternative. As Chuck suggested yesterday, investors may be wise to take advantage of a short term pull back due to yesterday’s interest rate decision.

The kiwi was down a bit overnight (wink wink) after the rate announcement. But its kissin cousin from across the Tasman, the Aussie dollar, was up again. The Australian dollar traded near a seven month high as a report showed a jump in employment. Australian employers added 11,400 full time workers in February, another positive move in what is the longest stretch of monthly gains since 2006. The good jobs numbers have pushed investors to predict another interest rate increase in Australia as early as June with increases continuing throughout the remainder of 2010.

Moving over to Europe, the Swiss central bank is scheduled to announce their interest rate decision later this morning. Most believe they will keep rates unchanged near zero, but many are expecting a more positive tone in the accompanying release. The central bank has intervened in the markets to keep the Swiss franc from appreciating too rapidly vs. the Euro. As the Greek crisis has pounded the euro, investors have been moving into the Swiss franc and Norwegian krone as alternatives. A more positive outlook by the Swiss central bank could generate another round of buying for the franc and test the central bank’s resolve to try and hold the value of the franc lower vs. the euro.

Speaking of the euro, the European Commission President Romano Prodi has declared the Greek financial crisis is officially over. “For Greece, the problem is completely over,” said Prodi, who was also the Italian prime minister. “I don’t see any other case now in Europe. I don’t think there is any reason to think the euro system will collapse or will suffer greatly because of Greece.” I read another story which quoted Harvard University Professor Martin Feldstein who said the euro’s 4.6% decline against the dollar has been nothing more than ‘panic selling’ stemming from the Greek crisis. He goes on to say the selling is irrational. A successful bond offering in Portugal yesterday seems to have taken some of the panic out of the markets, and the euro has settled into a fairly tight trading range lately.

The Pound sterling surprised me with a bit of strength overnight, snapping a three day decline vs. the Euro and US$. The pound rallied after a report showed UK inflation expectations had climbed to the highest since November of 2008. The BOE quarterly survey showed consumers predict an inflation rate of 2.5% in a year’s time. The pound had weakened through most of the trading day yesterday as a report showed manufacturing had unexpectedly contracted. Another factor weighing on the pound was a report produced by Fitch Ratings which said Britain is taking too long to cut its budget deficit.

So we have a country where inflation is heating up, but manufacturing is weakening, and deficits are running too high. Sounds like a recipe for a disaster to me! I really don’t understand why the pound sterling rallied, and would encourage investors to stay away from this currency. And unfortunately, the picture in the UK is eerily similar to what we will be facing here in the US; not pretty!!

We only had two pieces of data released in the US yesterday, and only have two more releases today. Wholesale inventories unexpectedly fell .2% in January which was the second straight decline. Inventories were increased during the last quarter of 2009, helping the US economy expand at a 5.9 percent annual rate. But recent numbers seem to indicate production and sales have reached an equilibrium, and the massive inventory liquidation of early 2009 is over. The other piece of data released yesterday showed the US budget deficit widened to a record in February. This is no surprise to long time Pfennig readers, as Chuck has been warning about the growing deficits for years. But the sheer size of this month’s $221 billion budget gap is almost beyond belief. At this pace, the US will certainly surpass last year’s $1.4 Trillion deficit. And there is no relief in sight, as the Obama administration continues to push spending programs and the economic recession holds down tax revenues.

Today we will see the trade balance along with the weekly jobs numbers. The trade deficit is expected to have increased slightly in January as a stronger dollar pulls down exports. The weekly jobs numbers are expected to have improved slightly from last weeks 469k, but the number is still predicted to be over 460k, a rather frightening number of newly unemployed.

On his way out the door, Chuck sent me the following note to include with today’s Pfennig:

Then there was this… Remember last week when I told you about the dire circumstances surrounding the Illinois budget deficit? Well… I know that I promised to take it easier on Gov’t officials who acts like dolts, talk like dolts, and do dolt things… So I won’t go there with the Gov. of Illinois, I’ll let you be the judge…

The Chicago Tribune reported yesterday that Illinois Gov. Quinn is planning on cutting 13,000 teachers and staff their jobs, cut off poor seniors from help in paying for costly prescriptions and shut down some health care programs for the indigent. But even after about $2 billion in cuts, the state would still be $11 billion in the hole.

I point this out to show you just how ridiculous it is that the currency markets are still taking shots at Greece, when states here in the U.S. are far worse off! Now… Back to Chris!

To recap: Chinese ‘bubbles’ pushed investors back toward the safe havens of the yen and dollar, New Zealand kept rates unchanged, Aussie dollars rallied, the pound sterling surprised with a gain, and the US data shows deficits continue to grow.

Chris Gaffney
for The Daily Reckoning