Daily Comment (October 10, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures have weakened on an unexpected jump in core PPI (see below).  Here is what we are following:

China: There were a few items of interest this morning.  First, Treasury Secretary Mnuchin warned China not to use a weaker currency to offset U.S. trade tariffs.[1]  So far, China has denied that it is considering a forced depreciation of the CNY.  However, the dollar/yuan exchange rate has weakened toward the CNY 7.0 level, which would be psychologically important.  For China, the exchange rate is a dual-edged sword.  An obvious retaliation against tariffs would be a weaker currency, which would offset higher costs on Chinese goods.  However, currency weakness in the past has triggered capital flight and any hint that the Xi regime is going to use a weaker currency could lead to outflows that would be hard to control.  We would expect a slow depreciation of the currency but most of the offset to tariffs is probably going to come from increased domestic investment, which will exacerbate China’s debt problem.  Second, during the just completed “Golden Week” in China, holiday purchases were said to be “soft.”[2]  Consumer spending during the holiday rose about 6.7% over the week, the first single-digit growth rate in post-reform history.  As the Chinese economy slows, we would expect the government to increase stimulus to avoid a slump.  Finally, Andrew Ross Sorkin has a report in the NYT[3] raising the age-old concern about China deploying the “nuclear option” and dumping Treasuries.  We discussed this issue from the Chinese side in a recent series of Weekly Geopolitical Reports.[4]  This is really not an issue.  As we noted in our reports, China has no real alternative to Treasuries.  If it decides to dump its holdings, not only would it suffer significant losses, but it would lose an outlet for its exports (which is how the reserves are generated in the first place).  However, there is another issue we didn’t delve into in the aforementioned reports—the Fed could simply execute a form of QE and purchase all the Treasuries the Chinese wanted to sell.

Trump and the Fed: President Trump criticized the Federal Reserve again yesterday.[5]  This Friday’s Asset Allocation Weekly will discuss the dangers of politicizing monetary policy.  There is a potential danger with White House criticism of the FOMC; the Fed really doesn’t control inflation (that’s a function of the intersection of aggregate supply and aggregate demand, meaning there are many factors affecting inflation with monetary policy being a minor one), but it does control inflation expectations.  If financial markets conclude that policymakers are “pulling their punches” to avoid disapproval, it would raise fears that policy won’t tighten enough in the face of inflationary pressures and un-anchor expectations.  We note that NY FRB President Williams suggested the Fed will likely reach a neutral policy level in “a year or so.”[6]

View the complete PDF

[1] https://www.ft.com/content/cd325c24-cc32-11e8-b276-b9069bde0956

[2] https://www.scmp.com/economy/china-economy/article/2167700/are-chinese-consumers-losing-power-soft-spending-golden-week

[3] https://www.nytimes.com/2018/10/09/business/dealbook/china-trade-war-nuclear-option.html

[4] See WGRs, China’s Foreign Reserves: Part I (6/4/18); Part II (6/11/18); and Part III (6/18/18).

[5] https://www.reuters.com/article/us-usa-fed-trump/trump-renews-fed-criticism-says-raising-rates-too-fast-idUSKCN1MJ2JW

[6] https://www.wsj.com/articles/feds-williams-more-gradual-rate-increases-will-keep-expansion-moving-1539133800