After the biggest money-printing episode ever recorded in human history, it appears that central bankers are realising the limits of quantitative easing. The Federal Reserve (Fed) has indicated that they are planning to raise interest rates. The Fed next meets on the 20-21st of this month.
Grandma Yellen indicated September and December rate hikes are on the table. Some analysts expect the Federal Funds rate to increase by 0.50% by year end.
Apart from banks and insurance companies, increased rates are not welcomed. Non-financial corporates have gorged on free money to complete stock buybacks and M&A deals. Higher borrowing costs will be disastrous for their highly levered balance sheets. That is why equity indices react negatively to any hint that the punch bowl will be removed.
Bitcoin dances to the beat of the PBOC. As I have written about on numerous occasions, the PBOC is staring at a banking system collapse of epic proportions. The amount of credit extended in the past eight years dwarfs the amount extended during the US Subprime Mortgage crisis by multiples.
As long as the Fed keeps rates low, the PBOC is able to quietly and slowly deleverage China’s collective balance sheet. A stronger USD makes Chinese goods more expensive globally. It also encourages more capital flight into a “safer” and stronger currency.
Each day at 9:15am Beijing time, the PBOC sets the USDCNY onshore exchange rate. Since August 2015, any time the Fed has hinted at or raised rates the PBOC has accelerated the devaluation of the Yuan. A devaluing Yuan signals that the global economy is not well, and deflation is being exported by the workshop of the world. That is not positive. As a result, during periods of Yuan depreciation, global equity markets fall.
Through quantitative easing the Fed attempts to push American savers and corporates into equity markets. Due to the lack of positive risk-adjusted and inflation-adjusted yielding assets, savers and corporates have responded correctly. The S&P500 is at all time nominal highs, and the US equity market has been one of the best performing markets globally since the Global Financial Crisis in 2008.
Given that a significant percentage S&P500 earnings are international, a faltering China signals global malaise. As such the index trades violently lower. When the S&P500 is falling, the Fed is in panic mode. It forces the same savers and corporates to dump shares in favor of cash. This cash will sit in a bank account, and the demand for credit will fall.
After a sufficient fall in the S&P500, the Fed relents and proclaims due to “market forces” the time just isn’t right for a rate hike. The PBOC then halts the devaluation, and the game continues into the next quarter.
Yellen’s Jackson Hole remarks were very hawkish. The rhetoric was subsequently backed up by various Fed governors during public speeches. The PBOC noticed and began weakening the Yuan towards 6.70.
If the hawkish rhetoric translates into action, the PBOC will allow onshore USDCNY and offshore USDCNH to trade much higher (the higher the level, the weaker the Yuan). Bitcoin reacts positively to a weaker Yuan.
If the Fed’s threats of a rate hike are perceived as credible, the market will attempt to front run the PBOC and short the Yuan by selling offshore CNH. In response, the PBOC instructed state owned Chinese banks to restrict lending of CNH in order to drive up the cost of funds. [Bloomberg] If you want to short CNH, you usually borrow it from one of the large Chinese banks. If the interbank CNH rates become prohibitively expensive, shorts are forced to cover.
Watch USDCNH, the PBOC has been defending 6.70 in the offshore market. If they allow that level to be breached, it means they are willing to tolerate a much weaker Yuan. Bitcoin will soar.
The best hope for a retaking of $700 and then $800 is for the Fed to raise rates next week. If the S&P500 nose dives before the meeting then the Fed will not hike, and all attention will shift to the December meeting.