Chinese RMB – Did Central Bankers Just Save The World? by Worth Wray, STA Wealth Management
“Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.” — Robert Shiller
On April 9th 2021, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. Q1 2021 hedge fund letters, conferences and more Read More
- Less than a month ago, it appeared that the strong US dollar and weakening Chinese RMB could soon usher in a global recession and a global financial crisis.
- But now, the world economy may be unexpectedly stabilizing on the back of a coordinated central bank intervention intended to weaken the US dollar and avoid a disorderly Chinese RMB shock.
- Together with ramping Chinese fiscal stimulus and an improving oil market narrative, the weak dollar may result in stabilizing commodity demand, a recovery in certain emerging markets, and a re-acceleration in the US economy.
- We still do not know if we are experiencing a temporary period of US dollar weakness (most likely) or a legitimate trend reversal (possible with structural change like the 1985 Plaza Accord), but we continue to watch for confirmation.
- Should this weak US dollar environment persist, we believe it may be favorable for equities, politically stable emerging markets, commodity producers, and midstream master limited partnerships (MLPs) in particular.
Did central banks just quietly save the world?
I wouldn’t go that far, but something clearly happened at the recent G-20 gathering in Shanghai that may have the potential to set the world economy on a new course… or at least defer a global recession for the time being.
Let me explain.
Strong US Dollar And Weakening Chinese RMB – 30 Years After the Plaza Accord…
In September 1985, finance ministers and central bankers from the G-5 (the United States, Germany, France, Japan, and the United Kingdom) gathered in secret at New York’s Plaza Hotel to coordinate a plan for weakening the US dollar and supporting the Japanese yen.
If you recall, the dollar’s meteoric rise from 1980 to 1985 triggered debt crises across Latin America, fueled manufacturing booms in Japan and Germany, and left the US painfully uncompetitive against other industrial economies.
In those days, Japan was the rising Asian power with an undervalued, slowly internationalizing currency. So as the dollar rallied, the US manufacturing sector languished, Japan enjoyed explosive export growth, and Congress turned toward the same kind of protectionism that undid global trade in the 1930s.
Rather than risk a similar collapse in international trade or allow emerging market risks to metastasize into full-fledged banking shocks, G-5 policymakers – including Japan – chose to collectively engineer a rebalancing in foreign exchange markets that would avert what seemed like an imminent disaster and set the world on a different course.
Thirty years after the Plaza Accord, that may be exactly where we find ourselves again as the simultaneous risks of a strong US dollar and weakening Chinese RMB threaten to derail not only global trade, but the entire global financial system.
Mutually Assured Destruction
Just a few weeks ago, it looked as if we were heading for that earth-shaking crisis. With the strengthening US dollar already near a breaking point for commodity prices, global trade, and market liquidity, it felt like my greatest fears were quickly coming true (see my stormy 2015 outlook for the US dollar & my January 2016 note on China’s RMB).
That may sound a bit extreme considering that the S&P 500 is now up on the year and trading above its 200 day moving average, but I believe we were right on the edge of a powerful deflationary shock similar to the Eurozone’s near-break-up in 2012.
With the Fed signaling as many as four rate hikes in 2016 just as the European Central Bank and the Bank of Japan prepared to weaken their respective currencies, it seemed like a matter of time until this “every central bank for itself” dynamic pushed the dollar to its strongest valuations since the mid-1980s and forced the People’s Bank of China to free-float its currency (the “renminbi” or “RMB”).
As I’ve warned for several years – along with macro legends like Mark Hart and Raoul Pal – the toxic combination of a strong US dollar and weakening Chinese RMB may be the single most dangerous catalyst for a global financial crisis in the world today. It doesn’t take much imagination to see how this kind of shock could work its way through our highly leveraged, highly interconnected global financial system with disastrous consequences for every economy on the planet.
Just think of the Asian Contagion in 1997, the subsequent Russian Flu in August 1998, and the failure of Long Term Capital Management a month later. If a small economy like Thailand – with minor trade and financial linkages to the outside world – set off a series of events that nearly took down the US financial system, just imagine what a far more powerful RMB shock would mean for modern markets where liquidity can evaporate in a flash.
Not only could a sudden drop in the RMB disrupt global trade competitiveness as the price of Chinese manufactured goods collapses, but it could send a wave of deflation washing over virtually every economy on the planet by forcing the trade weighted US dollar higher, driving commodity prices lower, ramping up external pressures on highly-indebted emerging markets, and squeezing the US economy into a painful recession. And that’s before we even consider the prospect of competitive devaluations as central banks around the world return fire in a currency war gone nuclear.
Sounds almost apocalyptic, doesn’t it? As Scottish hedge fund manager Hugh Hendry explained in a recent interview with Real Vision TV, we’re basically talking about the monetary equivalent of mutually assured destruction.
See full PDF below.