9 Dec 2011

China Monetary Easing- What does it mean?

Not surprisingly, the Reserve Bank of Australia cut interest rates for the second time in two months yesterday. The official rate is now down to 4.25 per cent. And if I'm right about the major China slowdown coming in 2012 (more on that below) you can expect to see further interest rate cuts next year.

That's great news if you're up to your neck in debt, but not so good if you're a saver. This interest rate shift – already underway – will have major implications for the Aussie economy and market next year. I'm going to devote a good portion of your next monthly edition, due out on 21 December, to what these implications are and more importantly, how it will affect our portfolio strategy.

In short though, here are some of the immediate issues to consider:

Official rates will probably fall further than they ordinarily would because of the banks' reluctance to pass on the cuts in full. Banks will try to maintain their world beating (and unsustainable) returns on equity by lowering interest on savings accounts straight away while holding off on cutting rates for borrowers. No real surprises there...

But this presents another problem for the banks. Lower interest rates on savings accounts will see previously strong deposit growth slow and probably reverse in 2012. This will only exacerbate the banks' funding costs, already pressured by the situation in Europe.

I'll go into this in much more detail in the monthly report but the point to think about here is that interest rate reductions will not pack the same punch as previous rate cutting cycles. This has implications for the banks and the housing market in particular.

China monetary easing – what does it mean?

The China bulls and 'soft landing' proponents got all excited when the People's Bank of China (PBoC) lowered its banks' required reserve ratio by 50 basis points last week, to 21 per cent. This was seen as a sign of the central bank using just one of the many 'tools' it has at its disposal.

The market loved it.

But let's put the move into perspective. First of all, what does it mean?

A reserve requirement ratio (RRR) of 21 per cent is the minimum amount of reserves China's banks must hold as a percentage of customer deposits. If you look at the chart below, you'll notice how China's RRR has increased sharply since about 2003.

This is because the RRR is used as a tool to try to offset the inflationary effects of maintaining a pegged currency. If you remember back to the October monthly report about why China would have a hard landing in 2012, one of the central themes was the yuan's peg to the US dollar. The peg is the mechanism that leads to lots of printing of yuan to offset the flow of dollars coming into China from the trade surplus with the US.

The dollars go into the foreign exchange (FX) account as an asset. On the other side of the ledger the PBoC creates yuan that sit as reserves in China's commercial banking system.

It's a bit complicated, I know. But what is important to understand is that the RRR is a function of China's rising FX reserves. The currently high RRR is not a sign of 'tight' monetary policy. It's purely a reflection of the ridiculous size of China's FX reserves.

And as I pointed out in the October monthly report, China's 2009–11 credit boom was hardly the result of tight monetary policy. So lowering the RRR might help at the margin but it won't increase the demand for credit and certainly won't reinflate China's property bubble.
China's Reserve Requirement Ratio

Source: BIS

Speaking of the property bubble, the rapid change in prices (to the downside) and sentiment over the past few months must be of concern to China's central planners. With inflation still elevated (predicted to be around 4.5 per cent in the 12 months to November) last week's cut to the RRR took the market by surprise.

The fact the PBoC acted while inflation is still a problem goes to show how worried the authorities are. The bottom line: This is a worrying sign and confirmation that China's slowdown is worse than expected.

But the market certainly didn't view things that way. This is where psychology comes into play. Despite loads of historical evidence to the contrary, investors have strong faith in authorities to manage the slowdown. You would've seen the same response when the Fed first cut interest rates – by a larger than usual 50 basis points – back in September 2007 in response to the bursting US housing bubble. And where did that... and the subsequent lowering of interest rates to zero... get them?

A rescue plan for the Eurozone – no, really.

This weekend – apparently – you'll be reading about the definitive rescue plan for the Eurozone. To be honest, I'm not sure what the actual plan is anymore and I don't know whether anyone else does either.

These euro engineers are really starting to lose the plot. Just a few days ago Merkozy (Merkel and Sarkozy in case you're not up to date with the latest European soap opera) told the holders of sovereign bonds that they would not suffer losses on any future bailouts. Who do these people think they are?

The promise is all about protecting banks and creditors and getting bond yields down to manageable levels in Spain and Italy. But it's insane. You can't tinker with the market mechanism (by declaring all reward and no risk) and not expect unintended consequences.

It's actually beginning to get a little scary. These career bureaucrats and politicians are sacrificing democracy and national sovereignty for the sake of the Euro project.

It will end badly.

As anyone who has been to Europe, or studied European history would know, the place is made up of many different countries, with different national identities, aspirations, animosities, cultures and beliefs. The only similarity is the currency. Trying to homogenise Europe for the sake of that artificially created construct will prove impossible.

But when ego and self-interest get in the way of common sense, guessing what happens next is hazardous.

This weekend's summit is all about delivering an outcome that will prolong the impossible. Markets have rallied in the 'hope' that something is in the works. My feeling is that Merkozy still doesn't really know what that something is. They'll go for the confidence inspiring headline – the bazooka play – but I think when 'the plan' is analysed it will come up short...again.

What isn't in doubt though is the Fed's desire to protect US banks. Last week's central bank intervention – where the Fed lowered the borrowing cost for European banks to borrow US dollars – was conducted because a very large French bank (allegedly Credit Agricole) was close to folding.

This would have caused a run on the European banking system, which in turn would have triggered all the insurance written on European banks via credit default swaps. US banks have written a huge amount of that insurance so Europe would bring down US banks too.

Hence the Fed's involvement. What that tells you is that systemic contagion will be avoided at all costs. As this global debt crisis deepens in the years to come (and it will) central banks will be forced to become even more involved in the markets.

It is still questionable whether equities in general will benefit materially from this intervention. But there should be little doubt that gold and silver will be the big winners.

Right now, precious metals is the only asset class I have a high conviction on over the next few years. There is simply too much debt, political incompetence, greed, corruption and intervention influencing the market for gold and silver not to continue rising in price.

So take this opportunity to continue to BUY/HOLD/ACCUMULATE the precious metals while we are in this consolidation phase. We are about four months into this consolidation period (see chart below) and my guess is it won't last much longer than six months, if that.

Silver's price structure is different (see chart below). It's currently trading just under its 50-day moving average (blue line). It silver breaks through this area I would expect some pretty rapid gains to follow.

But keep in mind silver is a heavily manipulated metal. Some of the biggest banks in the world have huge short positions in the silver futures market, which means they won't want to see it rise too quickly. So buy with a long-term view and learn to deal with the volatility.
Gold – Still in a consolidation phase

Source: Stockcharts

Silver – Ready to break higher?

Source: Stockcharts

No comments:

Post a Comment