This Snowstorm Will Blow the Yuan Even Higher

Joined : 23 Dec 2007 Posts : 241 Location : Nigeria

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

Ever heard of bad weather affecting a currency? No? Yeah, me neither until now. But China just got buried under its heaviest snowstorm since 1954. That's a long time.

This freak snowstorm has caused the Chinese yuan to hit the highest level against the U.S. dollar (7.1911) since it was "unpegged" back in 2005. In fact, the yuan rose 1.6% since the start of January. That's a huge start to the year, considering the yuan rose a total of just 7% in the last 12 months.

The Snowstorms Have Increased Food, Transportation and Energy Costs
Well, the snowstorm has destroyed 4.2 million hectares of farmland. So food prices will be going up. These include staples for the Chinese diet including rapeseed, vegetables and wheat just to name a few. The damage was so widespread that it spread across 16 provinces.

On top of this, there will be transportation problems because of this massive snowstorm. There will also be an added demand for heating. So both transportation and energy costs will rise along with food prices.

Inflation in China Already Has Seats in the
"Nose Bleed" Section
Consumer prices already topped 6.5% in December. That's double the government's target rate. This will only add to commodity inflation.

The best way to fight the rising commodity prices is by increasing your currency's value. This is the better road to travel when fighting commodity inflation. It's much more strategic than just fighting commodity inflation by raising interest rates.

China is starting to see the value in doing this too. So you'll see the value of the yuan rise at a faster pace than before. This "higher yuan" will also aid them when they have to import some of the meats and vegetables that they'd normally grow at home. The stronger yuan will buy more foreign goods than a weaker yuan would as they import goods to replace those lost by the snowstorm.

They have a "self serving" interest to see this exchange rate come up higher against the buck and other currencies. There's no doubt they'll get products from all over Asia including Japan, New Zealand and Australia. After all, billions of people would have to do without the basic needs of life (food and energy) if they didn't import from many of their Asian neighbors.

China Will Be Forced to Raise the
Value of the Yuan
However, this snowstorm isn't the catalyst for higher inflation, it just adds to the highest inflation rate in 11 years. The Chinese central bank raised rates six times last year. Policymakers allowed the yuan to appreciate 7% and the inflation rate only came down from 13.5% to 11.5%.

You can see they've got a lot of work ahead of them to get this "inflation animal" under control. They'll have to minimally accelerate the rise of the yuan and possibly raise rates again too. At this point, I believe they'll hold off before they act.

Check out the U. S. dollar vs. the Chinese yuan (USD/CNY) daily chart that goes back to 2005. Since the yuan was "unpegged" from the buck and allowed to float within a controlled band, the yuan has gained ground on the dollar each year. But this exchange rate could still increase much more. Expect the yuan to strengthen 8%-12% against the buck which will bring this chart down even further.

As the Yuan Strengthens, the U.S. Dollar Goes Down on the Chart Against It

Chinese and International Banks Are Positioning Themselves, You Should Too
So even now, local and international banks are buying up Chinese bonds in anticipation of the yuan's increase. The growth in China will slow and the growth in Chinese stocks will slow as well. So it's not a bad move on their part.
The bonds earn about 4% while their currency appreciates too. Not a bad deal. You should follow their lead.

So even though I see the dollar being supported against many currencies, I do see it continuing to go down against the yuan in the near term and long term.
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Making 'Cents' of the Headlines
The Fed's Ready to Abandon the Dollar to Boost Stocks

What's Happening:

Traders have been wondering all week: Would the Fed cut rates enough? And if so, will the stock market magically recover? Well, the Fed has cut rates by 125 basis points in a little over a week's time.

What I Say:

I'd call that some "serious cutting." Yet even that is not enough to "save" the market. The stock market originally responds by rallying about 200 points off of its lows of the day. But by the end of Wednesday, stocks were actually down. Those stock losses carried over into the Asian session and the Nikkei was unable to rally at the start of its session either.

Now it makes sense that the U.S. dollar fell when the Fed announced they were cutting rates. A central bank cutting rates is generally bearish for a currency.

However, have you noticed that the buck is the red-headed stepchild of the U.S. economy? Bernanke watches stocks and wants them to continue to increase. (Even still they fell.) Yet, he's willing to sacrifice the buck up to the "stock market gods." Well, he abandoned the dollar to throw his confidence behind stocks, and what did he get? Both stocks and the dollar sank.

Now we're really going to be in trouble if stocks and the greenback both sink. The dollar is almost touching its 30-year-lows. Check out the daily, one-year chart of the U.S. Dollar Index below.

"The Buck Stops Here" or Does It?

I know you've all heard the phrase, "the buck stops here." That's what all traders are wondering right now. Will the "actual" buck truly stop at these historic, 30-year-lows or will the index fall further? That's the million dollar question that even Ben Bernanke himself doesn't know the answer to.

But we've got a "strong dollar policy" right? You can see how much good that's done us by looking back at that chart above. That's got to be the biggest joke at the U.S. Treasury.

While the government's maintaining their so-called "strong dollar policy," the anti-dollar (the euro) hit an all-time high. So if anyone has had a strong currency policy, it has been the Eurozone and not the U.S. Treasury or Federal Reserve.

The Fed's men and the politicians in Washington are wasting their breath by trying to convince us. At least when the Bank of Japan talks about strengthening its currency, the markets respect it and stop shorting it. But the "mighty U.S. Treasury" is all bark and no bite.

Now if the buck drops much further, it's very possible a few more Middle Eastern countries will drop their dollar pegs (Kuwait already did). If one does it, then more may follow.

If more "dump" their dollars at a time like this, then the buck would really be in trouble. Many Middle Eastern countries have already met over this issue and have voiced their concern. It's bad enough that oil is being traded in euros in that part of the world. What if it starts a trend?

So the U.S. Treasury and the Fed both have their work cut out for them. They'd better get busy doing something to "engineer" the strengthening of the buck just as hard as they have tried to prop up stocks.

It's a very touchy time in America with politicians running for election. They know that everyone can tell you roughly where the Dow Jones Industrial Average is at. However, many can't tell you where the U.S. dollar is trading and why it really even matters. They immediately feel it when their 401k's and IRA's go down. But your average American doesn't immediately notice the huge "macro" downward pull of the sinking dollar.

That's a lot of the reason why politicians, The Fed and The U.S. Treasury are all so focused on stocks.