Friction, Baby

Q. What do you think of global warming?

A. I think it would be a good idea!

Another day, another day of snow here in the southeast of England. The snowmen built by the Macro boys a week ago are still standing (albeit with a Quasimodo-like posture), and still the white stuff comes down. It seems as if Macro Man has seen more snow this winter than in the dozen prior winters combined. Small wonder that "global warming" has morphed into "climate change"!

Now, one might have thought that after a week's worth of snow, an additional inch or two would not have been too big of a deal. Fat chance! The 45 minute delay on today's morning service was put down to "slippery rail conditions." Funny....Macro Man was under the assumption that minimizing friction was one the engineering requirements of the modern electrified rail system.

Regardless, if there is insufficient friction on Britain's rail network, Macro Man's old mates in China are providing some. As if mocking your author for pooh-poohing their "decisive" move on bill yields yesterday, PBOC announced that they were raising banks' required reserve ratio to 16% (from 15.5%) scant hours after yesterday's post.

Now, in the grand scheme of things, this doesn't mean a whole lot. Before the onset of the financial crisis, these types of announcements a) used to throw markets in a tizzy for a few hours, and b) generated little meaningful impact. And to be sure, the PBOC hit the tape suggesting that policy was going to remain supportive of the ongoing recovery.

That having been said, there seems to be little dispute that the policy mix in China has been little short of an orgy of liquidity, as Macro Man observed six months ago. And if we combine the signalling mechanism brought about by:

a) this RRR hike
b) measures designed to curb property speculation
c) the introduction of equity index and futures and short selling in the A share market

we might well find that there is an impact on asset prices. It is perhaps notable that since bank lending growth was dialled down in H2 of last year, the Shanghai Comp has gone more or less nowhere. A sustained, if modest withdrawl of liquidity could encourage a dive below the bottom of the wedge below.
While taking A share risk is not necessarily that easy, punters can easily short H shares via Hong Kong-listed futures. The charts look broadly similar, and while A shares may lead the way to the downside it is difficult to believe that H shares won't suffer if onshore equities dump.

There's also been decent interest in paying Chinese rates via non-deliverable swaps. While this trade looks great optically (2y NDIRS rates are just over 3% for a double digit growth economy!), Macro Man is less certain that the trade will work because

a) interest rates are a sadly seldom-used policy instrument in China
b) carry is sharply negative
c) there is a lot priced in; 2y NDIRS have retraced much of their decline from the mid-'08 highs (when inflation was high, oil was $145/bbl, the 'Comp was close to its highs and activity was chugging merrily along.)

And what of the currency? Ah, good question. Macro Man would love nothing more than to be wrong in his non-prediction of no move in H1, but he stands by his call. Unlike fiddling with property regulations and inducing a bit of selling in stocks, moving the currency probably would have deeper macroeconomic implications....not only for the trade surplus, but also for liqudity conditions (if PBOC is "forced" to intervene heavily and is unable to sterlilize all of it.)

Introducing a bit of friction into asset markets is one thing. Giving into Western demands for currency strength (amidst a rising drumbeat of tarriffs, no less!) and potentially threatening the jobs or marginal unskilled labourers is something else. Macro Man remains sceptical. And so, from his perch, if one has a "China tightening" itch that requires a good scratch, the equity trade is the implement that will do the best job.