Every time there is a little blip by China in its purchasing or holding of US treasuries, hyperinflationists come out of the woodwork ranting about the “Nuclear Option” of China dumping treasuries en masse.

Such fears are extremely overblown for several reasons.

1. China’s purchasing of US assets is primarily a balance of trade issue. If the US runs a trade deficit, some other countries ruin a trade surplus and thus accumulate dollars. This is purely a mathematical function as I have pointed out many times.

2. If China dumps treasuries for Euro-based assets, oil-based assets, yen-based assets or for that matter anything other than dollar based assets, the problem merely shifts elsewhere and those buyers would have to do something with the dollars such as buying US treasuries or other US assets. This too is purely a mathematical function.

3. If China dumped treasuries it would tend the strengthen the RMB and China has been extremely reluctant to let the RMB appreciate. Indeed, the US is begging China to revalue the RMB upward, but China resists.

While China may make short-term moves in its reserve holdings, the odds of China dumping treasuries or dollars in size is quite remote.

Capital Tsunami Is The Bigger Threat

Michael Pettis discusses those ideas and more in The capital tsunami is a bigger threat than the nuclear option.

An awful lot of investors and policymakers are frightened by the thought of China’s so-called nuclear option. Beijing, according to this argument, can seriously disrupt the USG bond market by dumping Treasury bonds, and it may even do so, either in retaliation for US protectionist measures or in fear that US fiscal policies will undermine the value of their Treasury bond holdings. Policymakers and investors, in this view, need to be very prepared for just such an eventuality.

… the idea that Beijing can and might exercise the “nuclear option” is almost total nonsense.

In fact the real threat to the US economy is not the dumping of USG bonds. On the contrary, in the next two years the US markets are likely to be swamped by a tsunami of foreign capital, and this will have deleterious effects on the US trade deficit, debt levels, and employment. Investors and policymakers should be far more worried that China and other capital exporting countries are trying their hardest to maintain and even increase their capital exports, while the capital importing countries are either going to see capital imports collapse, or are trying desperately to bring them down.

So why not worry about Beijing’s “nuclear option”? For a start, unlike you or me the PBoC cannot simply sell Treasury bonds, pocket the cash, and go home. Dollar bills are just as much obligations of the US government as are USG bonds, only that they pay no interest. If the PBoC wants effectively to reduce its holdings of USG bonds it must swap them for something else.

So far, the discussion is purely on mathematical statements of fact. Yet most writers, especially the hyperinflationists, fail to understand simple math.

Should China Dump Dollars For Commodities?

Some want China to dump dollars for commodities and stockpile them. Does this make sense?

Not really, as Pettis explains.

Because of the positive correlation between Chinese growth and commodity prices, stockpiling commodities is a bad balance sheet decision for China.

Why? Because by locking in relatively “cheap” commodities if Chinese growth subsequently surges, or relatively “expensive” commodities if Chinese growth subsequently stalls, it will only exacerbate volatility in China’s already incredibly volatile economy.

This exacerbation of volatility is made worse by the widespread suspicion that China has already stockpiled huge amounts of commodities, but the main point is that even if the PBoC were to do this, it does not change anything material. It simply reassigns the problem to commodity exporters, with almost the same net results, because if Brazil, say, sells more iron ore to China, Brazilians now have more dollars, which they must either spend on US imports – thus boosting US employment – or invest in US assets. In this case Brazil simply intermediates the former PBoC purchases of USG bonds.

Finally the PBoC could sell US Treasury bonds and purchase assets in China. This would be most damaging for China because it would mean a drastic reversal in the country’s currency regime. The PBoC currently sells huge amounts of renminbi to Chinese exporters in order to keep down the value of its currency. Suddenly to switch strategies and to buy renminbi would cause the value of the renminbi to soar. This would wipe out China’s export industry and cause unemployment to surge.

So basically any sharp reduction in China’s Treasury bond holdings is likely either to be irrelevant to the US or to cause far more damage to China than to the US. I really don’t think we should waste a lot of time worrying about the nuclear option.

The Capital Tsunami

Pettis goes on to argue the real problem is exactly the opposite of what most are ranting about. While I mostly agree with what Pettis has to say, I strongly disagree on one point. Let’s tune in.

The problem facing the US and the world is not that China may stop purchasing US Treasury obligations. The problem is exactly the opposite.

The major capital exporting countries – China, Germany, and Japan – are desperate to maintain or even increase their net capital exports, which are simply the flip side of their trade surpluses.

China, for example, is unwilling to allow the renminbi to rise against the dollar because it wants to protect and even increase its trade surplus.

Japan is in a similar position. In Japan, consumption growth has been glacially slow, and any contraction in its trade surplus will lead almost directly to reduced production and higher unemployment, so Japan, too, is eager to maintain capital exports.

Finally Germany, like China, has been reluctant to put into place policies that boost net demand, and in fact the collapse of the euro means that Germany’s trade surplus will almost certainly grow. Needless to repeat, if the German trade surplus grows, so must its export of capital.

So who will import capital?

Here the situation is dire. The second largest net importer of capital until now has been the group of highly-indebted trade-deficit countries of Europe – including Spain, Greece, Portugal, and Italy. The Greek crisis has caused a sudden stop to private capital inflows, as investors worry about insolvency, and it is only official lending that has prevented defaults. These countries are unlikely soon to see a resurgence of net capital inflows. The world’s second-largest net capital importer, in other words, is about to stop importing capital very suddenly. I discuss this more generally in my May 19 blog entry: Don’t misread the trade implications of the euro crisis for China.

This leaves the US. Because it has the largest trade deficit in the world it is also the world’s largest net importer of capital. So what will the US do?

At first nothing. As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge. And at first they will surge. Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit. This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

Whoa! Stop right there.

Please read that last paragraph again.

While I agree that the math MUST balance, to say that attitudes play no part in the formation of that math is simply wrong.

If consumers decide to stop buying goods from China there is almost nothing China can do about it? Why? Wages!

Chinese Exporters Under Severe Pressure

Chinese exporters are already under severe price pressures. Yahoo!News reports Wages are rising: Companies brace for end of cheap made-in-China era

Factory workers demanding better wages and working conditions are hastening the eventual end of an era of cheap costs that helped make southern coastal China the world’s factory floor.

A series of strikes over the past two months have been a rude wakeup call for the many foreign companies that depend on China’s low costs to compete overseas, from makers of Christmas trees to manufacturers of gadgets like the iPad.

Where once low-tech factories and scant wages were welcomed in a China eager to escape isolation and poverty, workers are now demanding a bigger share of the profits. Many companies are striving to stay profitable by shifting factories to cheaper areas farther inland or to other developing countries, and a few are even resuming production in the West.

Labor costs have been climbing about 15 percent a year since a 2008 labor contract law that made workers more aware of their rights. Tax preferences for foreign companies ended in 2007. Land, water, energy and shipping costs are on the rise.

In its most recent survey, issued in February, restructuring firm Alix Partners found that overall China was more expensive than Mexico, India, Vietnam, Russia and Romania.

Mexico, in particular, has gained an edge thanks to the North American Free Trade Agreement and fast, inexpensive trucking, says Mike Romeri, an executive with Emptoris, the consulting firm.

Attitudes Are The Key

This has everything to do with attitudes.

If US consumers decide to hold out for lower prices, China will be in an enormous squeeze, unable to cut prices much.

I agree 100% with Pettis that Europe will not pick up the slack. However it is not a mathematical certainty the US will pick up the slack. Perhaps no one picks up the slack. Given the math must balance, pray tell what is stopping a collapse in global trade?

Nothing as far as I can see. It all depends on consumer attitudes. Certainly Bernanke and Congress will do their best efforts to get banks to lend and consumers to spend, it is by no means a certainty the Fed will succeed.

Bernanke’s Deflation Prevention Scorecard

Indeed Bernanke has already failed to prevent deflation as noted in Bernanke’s Deflation Preventing Scorecard.

Also see Are we “Trending Towards Deflation” or in It? for current conditions.

Moreover, given the highly likely dramatic shifts in the next Congress and given the appetite for more stimulus efforts now has nearly dried up, it is problematic at best to suggest Congress will keep consumers happy and spending.

Furthermore, cutbacks in state budgets are just now beginning to severely bite. Those cutbacks have to be factored in unless sugar-daddy Congress steps up to the plate.

While Congress may partially bail out the states, don’t count on it, especially in entirety.

Can Global Trade Collapse?

Given that Bernanke has already failed once, and in a big way, why can’t he fail again? I suggest he will. Regardless of the outcome (even if Pettis is correct), consumer attitudes towards spending and debt will determine the global trade imbalance math NOT preordained math deciding the role of the US.

The result may be a collapse in global trade, not an inflationary event to say the least.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Mike “Mish” Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.
Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific.

Go to Source

Go to Source

The EURUSD is vulnerable. Dropping below the short term channel (wave v of C) would suggest that a top is in place.

Go to Source

Sharp drop in early European trading and a bounce that fell short of closing above the hourly EMA10 should produce further downside in the US session. The 1.3045 was taken out, held during a retest, and is now acting as an important resistance level. There is strong support at 1.2965, and I expect price to move there and pause. A break below 1.2965 could see a quick move to 1.2890.

RSI has broken below its rising trend line support, and is expected to stay in bearish territory, below that trend line.

My short trade is in play and I tightened the stop to 1.3093 (entry). Target is still 1.2345.

Hourly Chart:

The break of 1.3045 finally came last night, but there is very little follow through. The 3-day sideways consolidation phase should have produced a more explosive upmove, and the fact that price could only rally 40 points within the first 4 hours of the break may be a sign that the Dollar is about to make a comeback. The EURUSD is facing strong resistance in the 1.3120…1.3130 area, where the 61.8% Fibo retracement level of the 1.5143-1.1875 range lies, and the 1.27 extension of a recent hourly range. There is a bearish divergence forming on the daily RSI chart. Hourly RSI is bullish looking with a break above the rising trend line, but is in overbought territory.

Many other currency pairs (AUSUSD, NZDUSD, USDCHF, USDCAD) are at major key support/resistance levels, and show early signs of topping/bottoming out. It’s too early to declare the beginning of a USD rally yet, but the evidence is mounting that it may just be around the corner (we may see it within a day or two).

I went short at 1.3092 with a tight stop at 1.3145. This is clearly a trade against the daily trend, but low risk/return and major structure support in the 1.3090..1.3125 area are in favor of the trade. The 1.3090 area was also major resistance in late 2008 and early 2009. 1.3250 is a too obvious resistance area and would encounter a whole army of bears that will go against it at that level. I believe it is likely we will see the pair roll over ahead of this level, and the 1.3090…1.3125 level may well be it.

My short entry at this level is also attempting to trade a 3-Drives pattern that has formed on the daily chart in the 1.1875-1.3106 range. Target for the trade is 1.2345, the 38.2% level of this range.

Hourly Chart:

Daily Chart:

I exited my long position at 1.2978 for a 32 point profit due to the close below the hourly EMA48 and lack of upside follow-through after 3 attempts to break higher.

The pair broke to new highs in European trading, and further upside is expected. Hourly RSI is still capped by a declining trendline, which is a concern for the long trade. But there’s plenty of scope for a sustained rally into the 1.31’s and even 1.32’s.

I tightened my stop to 1.2873.

Hourly Chart:

Converging moving averages last week were followed by a failed downside breakout, and price has consolidated near hourly highs since. Good 38.2% Fibonacci support on the overnight pullback and immediate bounce back above the hourly EMA10. Really bullish looking, with hourly RSI staying in bullish territory and room for upside. I’m expecting a move to the 1.27 extension of last weeks hourly move and key resistance at 1.3000. I went long at 1.2946 with a stop 1.2777, and a soft target of 1.3250.

Hourly Chart:

Key support/resistance level at 0.7288 was broken last night, and price has consolidated above that level since. The Gartley Sell Pattern is now a failed one, and the reason for my short trade has disappeared. I exited my short trade at 0.7306 for a 30 point loss. RSI has broken above a falling trend line, and there is real risk for further upside.

Hourly Chart:

Gartley sell pattern has formed on the hourly NZDUSD chart. Price is near the starting point of the Gartley pattern and is testing 0.7288 for the third time, potentially forming a triple top. This level is near very strong historical resistance at 0.7310..25. I went short NZDUSD at 0.7276 with a stop at 0.7340 and a target of 0.7132, the 38.2 Fibonacci level of the AB=CD part of the Gartley pattern. Trading against the daily trend here, which is a concern, but risk/return ratio is too good to pass it up. Hourly RSI is in favor of this trade. First support comes in at 0.7230, then at 0.7190.

Hourly Chart: