Gnome vs. Dragon

Last Friday, Grandma Yellen, aka The American Garden Gnome, spoke at the Jackson Hole symposium. While Obama was golfing, Yellen, the real master of the universe, spoke about the future of US monetary policy.

Yellen green-lit a rate hike sometime in 2016. Whether it happens before or after the US election is debatable, but it is definitely on the table.

The PBOC Governor Zhou, aka The Chinese Grand Dragon, is grappling with the largest credit bubble in human history. While the PBOC is very patient, rising USD rates are not desirable. China is attempting the largest-ever economic rebalancing in human history, from an investment-led to a consumption-led economy. Those who got rich over the last 50 years will see their economic benefits eroded in favour of household consumers.

This process is politically dangerous. Many elites are not happy, but Xi Jinping’s anti-corruption drive is quickly bringing them to heel. Last week the former head of the National Bureau of Statistics was indicted on corruption charges [Reuters]. This is the dude who cooked the books, but in reality he was only doing what he was told. Now he faces a bullet. The message is clear.

Even though the stated policy from Beijing is to economically empower households, credit is still being extended on generous terms to State Owned Enterprises (SOE). Beijing isn’t all stick, a carrot must still be extended to ensure support amongst those with local power bases. The PBOC is fighting a herculean battle to ease on one hand, and tighten on the other.

The PBOC’s task becomes increasing difficult with a strong USD since China decided to hitch its star to the USD. China from the 1980’s until now has exported goods and capital to America. The DXY Index (US Dollar Currency Index) weakened to a low of 72.00 in Spring 2008. Since then, it has rallied over 33%. The CNY has strengthened 5% in USD terms and manufacturing wages are up 128% over the same time period [Sources:TradingView CNY, TradingView DXY and Trading Economics]. In FX terms, Chinese goods are 38% more expensive, and profit margins of manufacturers are collapsing. Further USD strength will be crippling to the economic base of China. A strong USD also intensifies capital outflows as rich citizens rush to convert their wealth into a strong and rising USD.

Each time the Fed has thought about or actually completed a rate hike, China has responded forcefully by devaluing the Yuan. A weaker Yuan causes ripples of volatility in the global markets. The most profitable trade since the Global Financial Crisis has been to short volatility. The whole investing world is short interest rates, especially on the long end of the yield curve. This negative convexity will wipe out whole swaths of the investing public if volatility rears its ugly head again. The Fed will do whatever it takes to forestall the day of reckoning.

Yellen, in the past, has cited concerns over global capital market volatility as a reason why rates were not raised. The PBOC will exploit the Fed’s fear of volatility by resuming the CNY devaluation.

The Fed communicated that a summer rate hike was on the table. China scuttled those plans by weakening the CNY to 6.70 in mid-July. After the Fed backed down, The PBOC then allowed USDCNY to fall to a low of 6.62 in mid-August. CNY has been weakening ever since, and today they weakened the CNY further to 6.6856.

The Fall 2015 Bitcoin rally began with the game changing 1% devaluation of the CNY in August. The Fall 2016 Bitcoin rally will be sparked by a tit for tat devaluation of the CNY aimed at deterring the Fed from raising rates. The Fed’s credibility is on the line even more so than before. This time the Garden Gnome might snuff out the Dragon. The ensuing fireworks will be very positive for Bitcoin.