One week ago, our post “China’s Record Dumping Of US Treasuries Leaves Goldman Speechless” which revealed an unexpected plunge in China’s foreign exchange reserves or, said otherwise, a historic sale of US Treasurys held by official and unofficial Chinese accounts, was met with unprecedented public interest, having been read over 400,000 times (a record for coverage of a nuanced, technical subject) and even forced Goldman to follow up admitting its “estimation” of Chinese reserve outflows may have been too high.
By then the cat was out of the bag, and now what is surely the biggest Chinese wildcard, not what happens to itts manipulated stock market, just how much more capital outflows will Beijing suffer before it is forced to finally end the Renminbi’s peg with the dollar, is finally being appreciated by the general public.
Which leads us to today’s most recent article by ERI-C’s Russell Napier titled “The Great Reset – Act II“, in which the former CLSA strategist, asks a simple question:
“how US Treasury bulls in the private sector would react if they knew in advance that the second largest owner of Treasuries, the PBOC, was a forced seller of Treasuries. Such compelled selling would be obvious before US markets opened each morning as downward pressure on the RMB exchange rate in Asia forced the PBOC to liquidate foreign currency assets to defend the fixed exchange rate. Would even Treasury bulls stand in the way of such a large and predictable liquidation? If they didn’t then the second phase of The Great Reset would come to pass and the decline of EM external deficits would force tighter monetary policy in both EM and DM.”
For his answer, read on. Courtesy of The Electronic Research Interchange
* * *
The Great Reset – Act II
Do you love me, or are you just extending goodwill?
Do you need me half as bad as you say, or are you just feeling guilt?
I’ve been burned before and I know the score
So you won’t hear me complain
Will I be able to count on you
Or is your love in vain?
– Bob Dylan – Is Your Love in Vain? (1978)
In May 2011 this analyst changed his mind about the impact of the monetary love being spread around the world by developed world central bankers. He stopped forecasting higher inflation and instead foresaw the return of deflation.
Fresh from the battering in the deflationary storm of 2007-2009 investors did not want to hear that such monetary love would be in vain. They counted on central bankers then, just as they are counting on them now, to restore a level of nominal GDP growth that can prevent the severe burning of another painful deleveraging through default.
Central bankers, the argument goes, need to boost financial asset prices to achieve higher nominal growth and that higher growth, when finally achieved, will be good for asset prices anyway. So while their love may be for higher nominal GDP growth, the goodwill this spreads to asset prices should be priced in if it succeeds in creating inflation. However, a list of some prices that have been falling from last year — gold, steel, iron ore, copper, crude, coffee, cocoa, live cattle, hogs, orange juice, wheat, sugar, cotton, natural gas, silver, platinum, palladium, aluminium and tin — must raise questions as to whether there is reflation or whether this monetary love is in vain.
This analyst is told that such major decline in prices across a broad spectrum of commodities and products represents a supply shock and not the failure of central banks to spur demand! Such supply side synchronicity is highly unlikely. This is nothing less than a failure to reflate and it is due to the growing crisis in Emerging Markets (EM).
It was in a report called The Great Reset, in May 2011, that this analyst suggested the world was more likely to move towards deflation rather than higher inflation. There were many reasons for this change of mind, but key to it was a realisation that EM external surpluses had peaked.
That sounds like a rather esoteric reason to change from an inflationist to deflationist stance, and it was not one that was of any concern to investors. However, the end of a long period (1998-2011) when external surpluses, combined with exchange-rate intervention policies, forced EM to create more domestic high-powered money, while simultaneously depressing the yields on US Treasuries, seemed both important and deflationary. Crucially, The Great Reset predicted this decline in EM external surpluses would produce tighter monetary policy in both EM and the developed world despite the efforts of central bankers to prevent it.
This was not a dynamic that would inflate away the world’s record high debt-to-GDP ratio! This was a monetary mechanism, in the shape of EM exchange-rate targets, that would counteract the expansionary monetary policy of the developed world’s central bankers and thus would be bad news for global growth assets. This focus on the peaking in EM external surpluses and the impact on growth assets proved to be both a good and a bad forecast and remains essential to understanding the failure of monetary love to boost global nominal GDP growth.
As it happened, most EM foreign exchange reserves peaked in 2011, as did EM equities, EM currencies, commodities and the price of gold. Inflation rates in the developed world also peaked in 2011, with the US , the UK and the Euro area all since reporting deflation. So far so good for the May 2011 forecast with even European equities experiencing a slump in 2011 and not surpassing their early 2011 level until the end of 2014.
Crucially though, The Great Reset was very wrong about the US. US equities simply ignored the travails of Europe, EM and commodity markets and sailed ever higher. Ask any fund manager why developed-world equities ignored the deflationary trends since 2011 and they will point to the monetary love spread by The Federal Reserve, The Bank of Japan, The Bank of England and The European Central Bank. But fixating on the expansion of these central bank balance sheets has only distracted investors from the monetary tightening that started in 2011 and is now accelerating in EM as forecast in The Great Reset.
Most investors still believe that we live in a fiat currency world. They believe central bankers can create as much money as they believe to be necessary. Such truths are on the front page of every newspaper, but they may contain just as much truth as the headlines of their tabloid cousins. A belief in this ability to create money is the biggest mistake in analysis ever identified by this analyst.
The first reality it ignores is that money, the stuff that buys things and assets, is created by an expansion of commercial bank, and not central bank, balance sheets. The massively expanded central bank balance sheets have not lifted the growth in broad money in the developed world above tepid levels. Until that happens, developed world monetary policy must be regarded as tight and not easy.
The second reality that a belief in a fiat currency world refuses to recognise is the fact that the growth-engine of the world, the EMs, do not operate independent monetary policies. EMs have chosen to target the value of their exchange rates , primarily to the USD and the EUR, and thus abandon their ability to create money when they chose to. The scale of their money creation is dictated to them by the size of their external surplus. This is important to grasp when even a cursory look at changes in foreign-exchange reserves reveals that most EMs are constantly meddling to affect exchange rate targets and thus, abandoning any control they held over their own domestic money supply.
This is why The Solid Ground considered the end of the rise in EM foreign exchange reserves to be so key in shifting the outlook towards deflation and not inflation. The lack of reserve accumulation would either force deflation upon EMs or force them to devalue. The impact of either adjustment, whether through lower growth or lowered USD selling prices, would be deflationary and not inflationary.
Given the huge role China has played since its 1994 devaluation in spurring global growth, the adjustment process in China could be particularly detrimental to the stability of global prices. Events of the past few weeks are finally focusing investors’ attention on the lack of monetary control in China and thus on the lack of control generally. Local owners of RMB denominated capital have been voting with their feet since 2012 and capital has been pouring out of the country. Now even foreigners are realizing that an external deficit, and a fixed exchange rate, do not lead to more money, reflation or any form of control over asset prices by the authorities.
The Chinese authorities have attempted to shore up their external accounts by getting their commercial banks to borrow USD to fund RMB activities, ramping the domestic stock market, suggesting the opening of the domestic debt market to foreigners, lobbying for RMB inclusion in the SDR and hoping for inclusion in the MSCI equity indices. At this stage they are failing and the continued contraction in China’s foreign exchange reserves is witness to a continued external deficit.
The Great Reset , which began with China’s first reported foreign reserve decline in 2012, is now accelerating. The ultimate destination for China is either to continue to support the exchange rate and accept ever lower growth, probably accompanied by deflation, or to devalue. Either option will further exacerbate global deflationary pressures and place huge pressure on other EMs that compete with China and are linked to the USD.
So could the liquidation of US Treasuries by EMs, in an effort to defend their exchange rates, also push up Treasury yields? This was the forecast in the May 2011 paper and it was very wrong. It was wrong because the Fed was an aggressive buyer of Treasuries, but the Fed is not currently in the marketplace.
Today the yield on Treasuries is set by the actions of foreign central bank activity and the global private sector. The Solid Ground has long wondered how US Treasury bulls in the private sector would react if they knew in advance that the second largest owner of Treasuries, the PBOC, was a forced seller of Treasuries. Such compelled selling would be obvious before US markets opened each morning as downward pressure on the RMB exchange rate in Asia forced the PBOC to liquidate foreign currency assets to defend the fixed exchange rate. Would even Treasury bulls stand in the way of such a large and predictable liquidation? If they didn’t then the second phase of The Great Reset would come to pass and the decline of EM external deficits would force tighter monetary policy in both EM and DM.
PBOC liquidation of Treasuries to support the RMB exchange rate would not be prolonged. Both the US and China would recognize the dreadful dynamics inherent in such a policy if it did indeed push Treasury yields higher. Very soon China would be given the permission to devalue its exchange rate and the nature of the pain to be endured by the global system would be of a somewhat lesser and somewhat different nature. It would, however, still be a deflationary adjustment.
One day we will tell those much younger than ourselves that once upon a time there was a large economy that ran a surplus on both its current account and on its capital account for more than twenty consecutive years. We will tell them, when they’re sitting comfortably, that because it went on for twenty years everyone assumed it would go on forever, despite the fact that such a thing had never ever been seen before. Then one day it ended. And the world thought that this would pass or, if it didn’t pass, they thought that it was not of great import.
Only years later did the world realise that the end of unsustainable double surpluses in China triggered what became known as The Great Reset. It all began with the sudden realisation that developed-world central bankers had no magic wand with which to reflate the world if China was forced to deflate or devalue. The first sign that the monetary love of developed world central bankers would ultimately be in vain was the collapse of commodity prices in 2015. What came next did not involve the words ‘happily’ ‘ ever’ and ‘after’.