We’re watching the reaction in four markets to gauge how the Christmas gift from the Kings of the East will affect global risk appetite. The People’s Bank of China increased both the benchmark lending rate by 25 basis points to 5.81 percent and the benchmark deposit rate by 25 basis points to 2.75 percent.
The rate hike is the second in the tightening cycle, which began on October 19 and compliments other monetary moves, such as increases in bank reserve requirements. The markets viewed the first rate hike in October as a positive event. Though most analysts were expecting several interest rate increases by the PBOC, the timing may catch some markets off guard. The recent upgrade of the U.S. economy may have bolstered the confidence of Chinese policymakers to be more aggressive in their fight on inflation.
Nevertheless, nobody knows for sure how markets will react and, most important, how the Chinese economy will respond to tighter financial conditions. Some smart people are betting China is “Dubai times a thousand” and even though they have been wrong thus far, their warnings do loom, at least, in our trading psyche as they’re just too smart to ignore entirely.
So here is what we’re watching:
Shanghai Composite: The main Chinese stock index is down 13.5 percent for the year and currently sits at 2,835. It has been hovering around and been supported by its 200-day moving average at 2,785. A major break would suppress risk appetite.
Hang Seng: The Hong Kong index is one of our main indicator species for global risk appetite. The Hang Seng is currently up 4.4 percent for the year and since rallying 20 percent off the May low, the index has been carving out a head and shoulders pattern starting in early October. For the past few weeks, it has been threatening to break the neckline of the pattern right around the current level. The Hang Seng divergence with other risk markets makes us the most nervous. The market is closed on Monday.
Crude Oil: After floundering for the first three quarters of the year, crude oil was the “catch-up” trade for Q4, rising over 15 percent since October 1 and is now up 16.2 percent year-to-date. There’s much chatter the market has internalized “peak oil” and crude is now driven mainly by these structural issues and less by cyclical forces. If the China demand story goes away for a few quarters as the tightening begins to slow the economy, and oil remains around the 90ish level, we’ll be converted. Otherwise, we’ll continue to channel our inner Jim Chanos and expect crude to take a hit here, which, by the way, we think will be spun as positive for U.S. markets.
Copper: The industrial metal has had a massive 225% move off its crash low, is up 50 percent from the 2010 mid-year correction, and up 28 percent year-to-date. Though copper has been driven by supply concerns, including a recent accident at a key Chilean copper export port, this is the one commodity that appears most over extended to us.
One unidentified company reportedly “has the potential to own at least 90 percent of the copper in warehouses monitored by the London Metal Exchange, the largest such position in two years.”
If this company is not fronting for an end user and is holding the position on spec, we’re wondering if they’re feeling a bit like Wiley E. Coyote as China turns the screws on its liquidity driven construction sector. We have no idea of the details behind this trade, but we know one thing for certain – traders love the smell of blood.
A continued move higher in copper as China moves deeper into the tightening cycle, however, would confirm Jeremy Grantham’s, “we’re running out of everything” thesis and may even set off some panic buying and a real blow-off.
Other markets: We’re also monitoring the Australia, Japan, Brazil and Korean equity markets as these economies are now more dependent on the China market for their exports than the U.S. market.
Our baseline scenario is for a knee-jerk sell-off in the markets, which is bought as the spin will be, as it was in October, that China is getting ahead of the inflation curve. This should also bolster the case the U.S. as the place to be invested in 2011.
Like everyone, our best guess how the markets play out here is an imperfection construction made by analyzing and internalizing data and interpreting it through a reflection in a clouded mirror or seeing it “through a glass darkly.” This is why we believe it is important to be in constant search of new dynamic leading market indicators that, though imperfect, act as the “shadows on the wall of cave” to help us figure out and confirm what really drives markets. Stay tuned.
