The Future of the Renminbi

If there has been one sure bet in financial markets over the last few years, it has been on an appreciation of the Chinese renminbi against the U.S. dollar.

The appreciation has been slow but steady. After a few years of managed appreciation, the renminbi was repegged during the 2008 crisis. In response to considerable pressure from the United States, the peg was removed  and the currency was re-'floated' in June 2010. However, the Chinese authorities continue to set the daily closing value and the renminbi has appreciated less than 7% against the U.S. dollar since then. Reputable estimates of the size of the undervaluation are as high as 70% (here), but my read of the 'main-stream' estimate has been about 20-30%.

 

This intervention has caused considerable furor in the United States. It seems like every six months (or is it a year?) there is a bout of political grandstanding surrounding whether the Treasury will be forced by the Senate to include China on their list of currency manipulators, which would pave the way for the U.S. government to impose trade sanctions. Of course, due to the symbiotic nature of the trade relationship between China and the United States, this never ends up happening, but the posturing appears to have started again (here).

The market however, sees things quite differently. The renminbi forwards market is currently pricing a depreciation of the currency against the U.S. dollar over the coming months.

In other words...

The best explanation I can come up with is that the market consensus is waking up to the Jim Chanos version of the Chinese growth story - economic expansion fueled by unsustainable credit growth which is financing enormous investment in overcapacity (here, starting at the 7 minute mark). While the renminbi forwards have moved in a manner consistent with the recent sell-off in Chinese equities and commodities, I was still quite surprised to see this pricing in the forward markets. Any divergence between these asset classes should be closely monitored moving forward.

Rececssion Ahoy!

On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.

Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.

Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).

Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates,  the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.

Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.

I do not have any strong feelings on net exports and feel that it is probably a wash.

Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.

I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.

European Blow-Up Risk - Hedge Edition

If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?

Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink

Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?