Monday, December 10, 2007

Feelin' groovy?

"Slow down. You move too fast."

- Simon and Garfunkel, The 59th Street Bridge Song (Feelin' Groovy)

Friday was the quietest payroll day that Macro Man can remember. Perhaps it was the lack of weakness in the figure, perhaps it was the looming decision from the Federal Reserve, perhaps it was the need to get on with Christmas shopping, or perhaps it was the hangovers. Whatever the cause, the market just didn't seem to care, as action was pretty lackluster in all markets last Friday.

This environment, of course, lends itself to contemplation of longer-term issues and/or specific themes. So, too, seems to be the case in Beijing, where the economic mandarins appear to be catching up on all the 60's Western music that was verboten during the Cultural Revolution. In particular, the folk stylings of Simon and Garfunkel appear to have caught on, with the 59th Street Bridge Song currently topping the charts.

Last week, the Central Economic Work Conference announced that it intends to shift the monetary policy setting to "tight" in an effort to rein in economic overheating and inflation. That presumably means that they don't believe that the rise in CPI inflation is merely down to temporary microeconomic factors, after all.

In any event, the first shot of the tightening campaign was fired over the weekend, when PBOC raised the reserve requirement ratio by a full 1% to 14.5% This was the first 100 bp rise in the RRR since 2004, the last period of intentional policy tightening in China. The move is probably not as bold as it appears; December traditionally sees a disproportionate amount of fiscal spending from central and local governments, which draws down their central bank deposit balances and puts liquidity into the system.

Nevertheless, it is probably still worthwhile paying attention to the authorities' preferences. The clampdown on new lending in Q4 has apparently been severe, and the authorities did manage to slow growth the last time they tried to, in 2004.

If we step into the "way-back machine", we can see that China's policy clampdown did appear to have significant market consequences. The most obvious starting point is base metals, given that China accounts for 40-50% of world demand for metals like copper and zinc. Looking at the Journal of Commerce industrial metals index, we can see that it basically went nowhere for more than one and a half years after the last policy tightening. One could argue that we've been in a range for the last nine months; nevertheless, if history were to repeat itself, we have another few quarters in store of sideways trade in metals .
To a degree, however, that's already in the price. Copper has fallen precipitously since early October, and at this point it looks like a poor place to layer fresh shorts. Perhaps it is worth selling, however, in the 330-340 region, which would represent a reasonable retracment of the peak-to-trough move.
An alternative trade might be the sale of commodity currencies like the AUD or ZAR; the problem there, of course, is that shorting them incurs a large amount of negative carry, whereas shorting copper is currently a positive carry trade via the contago'ed curve.
A policy move ostensibly at odds with policy tightening was the weekend announcement that China is tripling the QFII quota to $30 billion. This, for uninitiated, is the amount of foreign investment that the authorities are willing to allow into China's securities markets. On the face of it, the timing seems odd. Why tighten policy if you then allow foreigners to inject substantial liquidity into domestic financial markets?
A more Machiavellian interpretation is that having restricted foreign investment during the period of "easy money" in Chinese equities, the authorities are now more than happy to allow foreigners to pay the top and lose money on the way down. A middle ground interpretation is that the massive run-up in China stocks has, for the time being, cooled foreign demand for them, which makes now an ideal time to expand the quota, as it won't be immediately filled.
Whatever the motivation, the chart above and the apparent commitment to tighter policy would appear to suggest that anyone buying China shares at current levels may not be feelin' groovy in a few months. An interesting speculative short might be Chinese banks, who are seeing potentially profitable loans being replaced on their balance sheets with PBOC reserves paying a paltry 1.98% per annum. And if the economy ever does meaningfully slow, perhaps the old Asian bugbear of non-performing loans will rear its ugly head. Macro Man isn't brave enough to pull the trigger at this point, but he may look into the matter further and allocate a small amount of risk to the idea in coming weeks.


prophets said...


Couple interesting articles on inflation:

Price Measure Says Rate Can't Fall as Traders Expect

A Contrarian's Take on the World

Macro Man said...

Prophets, will have a butcher's. I suspect the Fed will take comfort from the recent decline in oil and other industrial commodity prices, such as those depicted in the post. They may also tell themselves that inflation didn't peak until late 2001 during the last cycle, so waiting for inflation to roll over may be too cautious.

Not saying that I necessarily agree with that, but it is pretty easy to at least defer inflation concerns in the name of heading off economic tail least in the short term.

Jin said...

Good article. Just a sidenote which might be off topic. Recently there were many posts here focus on China and Mideast. I assume that it is becasue your real investment work has something to do with the two economies. Have you planned to look at other opportunities, i.e., India, south america, eastern europe...?

Macro Man said...

Good question, Jin. Right now I think one of the most interesting macro themese out there is potential fracturing of the "Bretton Woods II" system as a result of inflationary developments in the pegging countries.

Given that China and the Middle East (and Russia) run more explicit pegs than those other regions, and have had a larger rise in inflation as a result, that's naturally where a lot of my attention tends to be focused.

China has always been of interest here since I started the blog, given its footprint on the global economy and financial markets, whereas the GCC focus has really only come about over the past few months, when the Fed started cutting rates and the regional CBs have had to decide whether or not to follow.

Anonymous said...


Sort of on topic, if you include the last question. Do you know if maintaining the Iranian Rial peg to USD requires them to purchase USD or Treasuries and/or keep USD reserves despite their protests to the contrary?

Macro Man said...

Anonymous, I have no real idea what Iran does, to be honest.

Andrea (Florence, ITALY) said...

Hi MM,

I see that your FX carry trade basket was triggered once again last week. I know you have a simple quant model for that. Would you like to explain the rationale of your model? I mean, when is it triggered?

My guesses for next CB's moves: FED down 0.25% and NB up 0.25% (please consider that I'm an FX paper trader, not a pro. But I guess my 10 yr 3.00% fixed rate mortgage ending on May 2009 would be considered the teasiest of teaser rates...)

Charles Butler said...

Maybe the bank took pity on you when they saw the kitchen you were going to inflict on the missus.

Andrea (Florence, ITALY) said...

Actually, I was THE bank - 3.00% was the teaser rate then applied to employees back in 1999, but somehow they never changed that even after I left the bank, three years later. The rate was pegged to the discount rate then applied by Italian Central Bank (2.50%), plus a 0.50% spread. Anyway, I should be paying a fixed 6.00% right now (not too bad, if compared to US subprime and near prime current standards).

How about the latest olive crop in Spain, Charles? Here in Tuscany has been somewhat of a mess, with many plants infected by some sort of a bug and major producers are therefore said to be increasingly importing oil from Spain, Turkey, Greece and Tunisia. Anyway, all these US and British guys have still a long way to go before really appreciating the taste of just squeezed olive oil...

Macro Man said...

Andrea, there is an indicator that I use (proprietary, but very similar to measures of risk aversion published by investment banks)to trigger me in and out of the carry basket.

I realize now I forgot to mention it in the text, but yeah it was implemented first thing yesterday.

Andrea (Florence, ITALY) said...

MM, I guess you're triggered in when your "risk aversion barometer" is pointing towards a low level (i.e. high propensity to take on positions in risky assets), and out when the viceversa is true. Is that right? Would you get to the same results by just using options' implied volatility?

Macro Man said...

Andrea, implied vols are a component of my and most other people's indicators. They are quite useful, but obviously do not tell the whole story.