China raises interest rates
Two weeks ago I suggested that a rate hike was all but assured from the People’s Bank of China. I expected the rate hike on December 11th. Instead, perhaps out of fear of causing a hard landing in their overheating economy, the People’s Bank stopped at raising reserve requirements at Chinese banks in an attempt to limit the amount of new credit entering the system.
But on December 25th while much of the Western world was busy opening gifts under a tree, the People’s Bank quietly raised the one year benchmark rate and the bank deposit rate by 0.25%.
As discussed before, the Chinese government fears one thing above all else: Civil strife and social unrest. They find themselves backed into a bit of a corner. On one hand, they need the economy to continue to provide jobs for the millions of young, single men who are the demographic by-products of China’s one child policies. An army of young, single men with no marriage prospects and no employment can quickly become a thorn in the government’s side. Yet at the same time, the inflation and excess credit creation that is creating the economic prosperity is also causing an overheating in the domestic economy as the new money pours into commodities.
With prices rising, people are finding that their hard-earned money is now buying less and less. When food prices rise a couple percent a year, it is a subtle tax that people blindly shrug off. But when the rise is significant (some estimates have food prices rising 20%), people’s reaction is much less benign.
This quote may well capture the PBoC’s concerns:
“It is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial worker unrest over erosion of living standards by inflation.”
In fact, a report by Chinese Academy of Social Sciences, a prominent research organization based in Beijing, reported that high inflation and housing prices had contributed to a deepening sense of popular disaffection, while the number of citizens satisfied with current price levels has sunk to an 11-year low. Against this backdrop, China had little choice but to risk a slowing of their economy in order to stem the tide of rising dissent.
But what of that risk of a sudden slowing in China’s economy? What impact would that have on commodity prices and the commodity-heavy currencies and economies of Canada and Australia?
While I maintain that commodities are still a long-term growth story, I think the near-term outlook is a bit concerning. Interestingly, Capital Economics recently noted that even a soft landing in Chinese GDP where annual growth slows to 8-9% would put strong downward pressure on commodities.
The reserve requirements in China have worked well at stemming credit creation since being initiated earlier this month. In fact, on December 23, the Chinese Ministry of Finance experienced its first failed bill auction since April as bank liquidity has quickly dried up. When the Chinese MoF could not attract sufficient bids for a bill auction back in April, it was followed by a two month stock market slump which brought many bourses (including the TSX) to their year lows.
Additionally, we have several strong indicators of slowing global demand for commodities. I recently highlighted the rapidly falling Baltic Dry Index as well as the incredible slowing in speed of the average dry bulk carrier out of China. Neither bodes well for the sustained bull market in industrial commodities over the near term.
Meanwhile, CFTC Commitment of Traders reports continue to show strong speculative positions in most commodities, a bearish contrarian indicator.
Finally, new data from the Dallas Fed’s Manufacturing Index indicates that both material and finished goods inventory surged in December. It may well be more indication that the inventory restocking that provided some nice buoyancy to both GDP and commodity prices may well have run its course.
While the long-term outlook for commodities and commodity-laden indexes like the TSX remains bright, the next year or so may prove to be a very bumpy ride indeed.