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Crescat Capital 1Q18 Letter: Chinese Yuan Devaluation; Inflationary vs. Deflationary Forces

  • Fed tightening has been a reliable catalyst for the bursting of asset bubbles globally. This time it will almost certainly be no different. Thus, we remain net short global equities in our hedge funds

The Coming Chinese Yuan Devaluation

  • In late 2014, People’s Bank of China switched to net quantitative easing versus the Federal Reserve when it began aggressively selling foreign reserves and buying domestic assets. In 2015 and 2016, USDCNY reacted as it should have to these fundamentals with the yuan declining. A currency pair’s value normally tracks the relative monetary policies of its central banks. In 2017, the Chinese central bank purchased close to $700bn of domestic assets. China is engaged in aggressive QE at the same time as the Fed is now in quantitative tightening mode portending a substantial devaluation of the yuan versus the dollar
  • The yield spread on 10-year Chinese government bonds compared to 10-year US Treasuries has narrowed further illustrating China’s relative QE compared to the US forming another alligator mouth that should snap shut again with the yuan declining
  • Versus the dollar, other emerging market currencies as measured by an equal-weight BRICS ex China index that we created have been heading down YTD while the yuan has been heading sideways, yet another alligator mouth. This is a similar setup to August of 2015 which foreshadowed periodic yuan devaluation. Outside the BRICS, the Turkish lira and Argentine peso have also plunged recently vs. the dollar indicating that the Fed’s tight monetary policy could be leading to a strong dollar similar to the late 1990s which catalyzed both the Asian and Russian currency crises
  • Access to dollar credit is tightening up as measured by the Goldman Sachs US Financial Conditions index which considers long-term Treasury yields, the federal funds rate, the trade-weighted dollar, the S&P 500 index, and investment-grade credit spreads. GS US Financial Conditions Index and emerging market stocks that rely on dollar credit are negatively correlated
  • Finally, the potential for a global dollar funding crisis is perhaps best illustrated by the recent widening of the LIBOR-OIS spread which is the widest since the GCF and looks similar to the same curve just prior to the Lehman default
  • China has dollar-denominated debt in its banking and corporate sector as well as dollar swap obligations in the FX market that China has used to maintain a strong currency against capital outflow pressure. While much of its debt is opaque, it is possible and even likely that China’s dollar obligations exceed its dollar foreign reserves making China dollar net short. Fed tightening makes it difficult for China to service and refinance its dollar denominated debt without selling its foreign reserves

Inflationary vs. Disinflationary Forces

  • Inflationary forces:
    • Rising fiscal deficit (tax cut)
    • Trade wars/protectionism
    • Fed policy too hot for too long per Taylor Rule
    • Lag effect of past easy monetary policy
    • Weak dollar in play throughout 2017
    • Late cycle inflationary pressures / tight labor force
    • Money velocity has turned up
    • Rising TIPS breakeven inflation levels
    • Strong PMI prices paid component
    • Rising long end of the yield curve
    • CPI/PCE might be understated
    • Necessities inflation: housing, food, health care, education
    • Oil has been rising
    • Gold and silver prices firming after long base
  • Disinflationary forces:
    • Demographics / aging population
    • High debt levels
    • Natural rate of interest may be near zero
    • Strong dollar resurfaced April 2018
    • Wage inflation still largely absent
    • Fed tightening could be too aggressive
    • Low money velocity
    • Long-term discouraged workers
    • Yield curve flattening
    • Liquidity dry-up / dollar funding shortage
    • Technology disruption
    • Low savings rate
    • Likely bursting of China credit bubble
    • Globalization
  • The current late cycle overheating risks point to rising inflation, with “cost push” forces becoming more apparent. If history repeats itself, the Fed is likely to tighten until asset bubbles burst (stocks, corporate credit, real estate perhaps)
  • Gold remains an excellent hedge for us under the ultimate inflationary scenario that we see playing out. Gold is also a haven asset with deep-value properties for added protection in the deflation scenario. Gold held up very well during crises characterized by declining inflation, dropping by only 1% on an average annualized basis during those periods

Crescat Capital 1Q18 Letter, May 12, 2018

Image Source: Bloomberg, Crescat Capital

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