The delicate dance of the U.S. Fed and the Central Bank of China
China's exports: Is the golden age of cheap labor coming to an end? (Part 3 of 6)
(Continued from Part 2)
U.S. Fed policy changes
The below graph reflects the change in monetary policy of the U.S. Federal Reserve Bank (Fed) from 2007 to date, as the overnight interest rate was lowered from 5.25% to nearly 0% after the 2008 financial crisis. After nearly five years of low interest rates, speculation has begun as to when the Fed will once again allow interest rates to rise, as the Fed has signaled that current levels of monetary accommodation could taper into year end.
Pegging the yuan to a monetary roller coaster
Federal Reserve (Fed) Governor Ben Bernanke was confirmed as the successor to Alan Greenspan on January 31, 2006, eight months before the October 2008 stock market crash. Alan Greenspan had been confirmed as the Fed Governor on August 11, 1987, two months before the 1987 stock market crash. You’d hope Bernanke’s successor next year would avoid a similar experience. Both Janet Yellen and Larry Summers should be careful what they wish for.
Alan Greenspan’s predecessor, Paul Volker, had extensive experience in raising interest rates to slay the Reagan era inflation of the 1980s. Federal Funds targeted rates reached the peak of 20% in 1981, but they were closer to 7% by the time Alan Greenspan took office. Alan Greenspan gained experience in both raising and lowering interest rates, having lowered rates to 1% after the dot com and 911 crises, though he left office with rates just over 5% in an effective effort to cool the U.S. housing market. (It was subsequently noticed that Greenspan’s rate hikes were more effective than he had anticipated.)
Greenspan had raised rates post-2004 to mop up excess liquidity in the system post dot com crisis, and to cool the U.S. real estate sector of the economy, whose prices had become, in his view, “a bit frothy.” Accordingly, Greenspan raised rates from 2004 to 2007 from 1.00% to 5.25%, as reflected above. Banks eventually reigned in commercial and residential real estate credit over the second half of 2006, and by June 2007, the credit wave had crested and was on its way down. The credit mechanism had thereby seized up mid-2007, and banks engaged in a synchronized withdrawal of credit unseen since the Great Depression.
Enter Ben Bernanke. When the U.S. Federal Reserve Bank, via the Federal Open Market Committee (FOMC), began to lower interest rates in late 2007, the U.S. dollar continued to weaken rapidly, having already weakened approximately 33% since 2002. Remember when the Euro bought 1.60 U.S. dollars? Investors saw this trend as the end of “King Dollar.” However, as this 2007 credit market seizure triggered an equity market collapse within 12 months, dollar naysayers were whipsawed in a “flight to quality” into the safe haven of U.S. Treasury securities. The dethroned “King Dollar” reclaimed its safe haven throne, and strengthened dramatically in reaction to the global crisis of 2008.
As U.S. interest rates reached the end of the easing cycle over the course of 2008, the U.S. dollar rallied nearly 25% against global currencies during the flight to quality over the next eight months, only to collapse once again over the next eight months as the crisis eased into 2011—so much for the flight to “quality.” However, the dollar has recovered since 2011, and it’s approximately where it was just before it began its 2007 collapse against global currencies: 10% lower than when Bernanke took office, and approximately 33% lower than the 2002 level, as reflected in the euro-dollar rate, among other rates.
Interestingly, while the U.S. dollar may be approximately 33% weaker against a basket of global currencies over the past decade, the slow and gradual appreciation of the Chinese yuan, especially post-2005 currency policy, has also seen an approximate 33% appreciation against the U.S. dollar. The yuan remained fairly weak and stable against the Euro until the 2008 financial crisis, but it has since appreciated roughly 25% against the euro, as reflected in the prior graph in this series. Should the yuan continue to appreciate against the euro at this rate, Chinese exporters would experience significant pricing pressures. Europeans would notice an increase in the cost of Chinese goods at some point.
Let me off this ride
The yuan’s recent appreciation against regional competitors over the past year, such as Japan and Korea, are developments that merit close monitoring. The current changes in global monetary policy could have a significant impact on these exchange rates. Higher interest rates in China could exacerbate yuan appreciation against the Japanese yen and Korean won. Looking forward to the next twelve years or next global business cycle, China may face the exact opposite foreign exchange experience.
Investors are starting to view the dollar as the least dirty shirt in terms of debt-laden global currencies—and it could drag up the yuan with it, reinforcing the post 2008-yuan appreciation versus the euro and yen and Korean won. It’s been a great run for China and its yuan, but you might suspect that the China Central Bank (PBOC) might prefer to be pegged to the Euro in the future, and opportunistically engage its “creeping peg” against a potentially weakening Euro instead of a potentially resurgent “King Dollar.” However, future dollar-euro exchange rates are difficult to estimate, and the EU challenges of bridging the monetary and political union chasm are daunting. These challenges still cast a shadow as to the viability—or at least volatility—of the euro in the future.
The monetary tightening of the China Central Bank needs to coordinate with the potential tightening or withdrawal of liquidity by the U.S. Federal Reserve Bank—not to mention the “Abenomics”-driven Bank of Japan inflationary offensive—a bit of a double whammy. Should U.S. central bank monetary tightening become premature and excessive, China could face intensifying pressures in its domestic economy and its banking system, and equity markets could thereby experience another round of weakness. Should Japan successfully orchestrate 2% inflation, its currency could continue to slide, and perhaps at some point manufacture Apple iPhones, if not Sony tablets. (But don’t hold your breath—the yen has a long way to go before that’s economically viable).
Outlook
Chinese monetary policy tightening could be exacerbated by two opposite though reinforcing forces: the cooling pressures of the U.S. Fed tightening in conjunction with the cooling effect of Japan’s central bank loosening and weakening its currency against the yuan, thereby increasing export competition in Asia. So U.S. markets, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), the State Street Global Advisors Dow Jones SDPR (DIA), and Blackrock iShares S&P 500 Index (IVV) may continue to outperform China in the near term. In the case of Japan, the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs could also continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and potentially Korea’s iShares MSCI South Korea Capped Index Fund (EWY) ETFs.
Continue to Part 4
