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Thursday December 29, 2005 - 18:22:55 GMT
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China view

“We must learn to differentiate clearly the fundamentally important, that which is really basic, from that which is dispensable, and to turn aside from everything else, from the multitude of things which clutter up the mind and divert it from the essential.”
Albert Einstein

FX Trading
One of the major themes we are working/watching/somewhat expecting to play out in 2006 is a surprise at the degree of slowdown in China. (We admit to the broken-clock theory on this one i.e. we will be right at some point—as we were expecting the same last year.)

Some argue that not even the broken-clock theory will work on China, as those wily Chinese leaders will continue to grow uninterrupted from here till at least eternity—after all, they are more powerful than the market, don’t you know, is the Chinese lovers’ lament.

Chinese authorities will keep the music playing at least until the Olympic torch is lit in 2008, many say. That view falls into the maybe category for the reason that if China does not allow some air to escape from the bubble now, the problems would be unbearable no matter how many gold medals around their necks.

So our view, based on others views that seem to know what they are talking about, is the air starts out—is already hissing out—now, and continues through the year and into early 2007, setting the stage for a new growth spurt, a sprint if you will, into the Olympic games in 2008.

Here’s the naysayer view in a nutshell: Overinvestment has led to overcapacity with has led to extremely thin profit margins for companies that must continue to have access to low cost capital AND export markets in order to survive.

Inherent in there are at least three major points that we glean, many more if you really try:

• China is forced to keep interest rates low in order to keep the music playing. Though policy markers know the economy is lopsided in favor of exports, a rebalancing of the economy to more domestic consumption will take time and a host of bankruptcies driven by excess capacity isn’t going to do much for employment or consumer spending.

• Inflation will remain low because of the capacity glut thus helping to justify low interest rates. But the real concern is slipping into deflation.

• Any revaluation of the Chinese currency will be muted by these real economic forces/problems. If this is true, and much of the speculative capital invested in Chinese real assets such as real estate is simply a way to take advantage of the “inevitable huge revaluation,” the disappointment related to the reality that it won’t be happening anytime soon could trigger a capital rush out of China at a critical time when liquidity is in big demand. Can you say “contagion?”

And if you can say “contagion,” as we can, you too would then believe that industrial metals are trading at dangerously high levels across-the-board.

Copper, Aluminum, and Platinum in the weekly chart below:

If we do see some hot money flow from China, we expect the corresponding fall in commodities to produce a safe haven trade into US Treasuries. And that move would likely be good for the dollar—at least initially.

Take a look at the divergence between the dollar and copper on a weekly basis below—based on that chart alone, it doesn’t look as though the dollar has “come too far” this year:

A safe haven Treasury flow would push rates down even more—we say that because we expect the housing deflation to push rates down soon. Such an event would likely raise the Fed’s deflationary guard and lead to talk of cut later in 2006, which in turn would like lead to “concerns” about the dollar yield differential.

We know it borders on silly to try to forecast such events with such precision, or any degree of precision for that matter. But we think the story is plausible and for at least today, we are sticking to it.

Jack Crooks
Black Swan Capital


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