This is Not Over - September 4, 2015

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Greetings,

On August 11, the PBoC shocked the market with a CNY devaluation that, while still relatively small, was the biggest drop in twenty years. China is slowly transitioning to a consumption-led economy but remains heavily dependent on the manufacturing sector for growth. A weaker currency makes Chinese goods more competitive on the global market, meaning the devaluation was essentially a form of stimulus. In economics, a strengthening local currency acts to tighten domestic monetary policy, and this principle is largely responsible for the ongoing Currency Wars.

Investors understand that a weakening local currency is supportive of domestic asset prices. What they don’t seem to understand is that a strengthening reserve currency tightens monetary policy on a global level. Just because global interest rates are near their lowest levels in history and QE programs continue in Europe and Japan, does not mean monetary policy is loosening. In fact, the chart below shows that global reserve assets, a good proxy for liquidity in the financial system, are in outright contraction. Of course, it’s no coincidence this decline has been mirrored almost perfectly by a historic rally in USD – the world’s reserve currency.

As with everything these days, the contraction in global reserves has been driven almost entirely by China. By pegging CNY to USD for the past two decades, the PBoC was able to accumulate several trillion dollars in FX reserves. Because USD was depreciating for much of that period, it always acted as a tailwind for global growth. However, the DXY Index has rallied 21% over the past 16 months and China’s FX reserves have declined by $350 billion.

To be clear, China still has $3.7 trillion worth of reserves to defend CNY from excess weakness, and the PBoC could reverse those outflows by simply opening up the economy. While China still has the capacity to boost its economy during a crisis, this USD rally shows no signs of slowing down. This week USD set new highs against local currencies in Australia, New Zealand, Thailand, Singapore, Indonesia, South Africa, Turkey, and Brazil. And those are just the tradeable currencies.

This is all related to the collapse in oil, which has been covered ad nauseam, but many fail to realize its impact on monetary policy. The price of oil is the dominant variable in the calculation of CPI. Since crude started falling in 2014, US CPI growth has dropped from +2.0% Y/Y to +0.2% Y/Y currently, and it should go negative in the coming months. That’s important because it means real interest rates are rising, tightening monetary policy.

Instead of studying the (ridiculous) notion that lower gasoline prices support the economy, policymakers need to realize they’re passively allowing monetary policy to tighten as the stock market rolls over. Forget about a September vs. October hike, the real debate should be when the next wave of stimulus is coming.

The Cup & Handle Fund is up around 6.5% YTD, and +26% Y/Y. I’d like to be up much more, but nothing about our thesis, which has been spot on so far, has really changed. I still like our positions and feel comfortable sitting with them (with small tweaks) until something changes. The monthly picks for July and August have been home runs. The September letter went out on Wednesday and it’s already 2% in our favor. If you’d like to start receiving these letters click here.

With that I give you this week's letter:

September 4, 2015

As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro

Posted to Cup & Handle Macro Research on Sep 04, 2015 — 11:09 AM
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