FX CONCEPTS FX CONCEPTS

GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH

CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


MARKET INSIGHT REPORT
The Black Cat, the White Cat and the Mouse
By John R Taylor, Jr.
Chief Investment Officer
Over the last four decades, the Chinese economy has become two economies, not one,
and that has proven to be a blessing for the Chinese leadership and the countrys
workers as well. The two halves, the government and the state owned enterprises on the
one hand (the white cat) and the private economy on the other (the black cat) have
supported each other in the sense that the health of one has historically been a positive
input for the other. Between the two cats, the mouse government survival and societal
advancement has been caught. The birth of this dichotomy starts a long time ago with
the reforms of Deng Xiaoping in 1976, immediately after he assumed power a bit after
Mao Zedongs death. His Household Responsibility System (HRS) put the family back in
charge of their lives and gave birth to private enterprise the second cat. As Deng said,
it didnt matter what the color of the cat was, as long as it caught the mouse. Dengs
revolution has proven incredibly successful, as China is a mixed economy powerhouse,
revolutionizing our perception of what a Communist system could be.
Fast forward to recent times, after the sharp downturn in 2008, the government pumped
many trillions of yuan into the economy, but basically all of that new money went through
the state owned banking system and as a result into the state owned enterprises
(SOEs), the Peoples Liberation Army (PLA) and other government entities. The private
sector basically missed the tremendous injection of new money, but it did receive help
from the shadow banking system and from capital inflows pushing money into the
country. Although both cats seemed very healthy before 2008, now it looks like there is
one fat cat and one hungry one, threatening to become emaciated as the drive to clean
up the shadow banking system moves forward. The balancing act between the two cats
has always been there. But while China was growing so quickly, with money very
plentiful and available to almost all projects, this problem was not apparent at least not
to us. Now that the capital is less available, the problems are popping up and the
critically important private sector needs help. In many ways, the SOEs have not done
the job and they have added to corruption, high living and conspicuous consumption
something the new government team, Xi Jinping and Li Keqiang, has vowed to control.
Xi and Li seem to recognize the difficulties in supporting the private side despite the
need to rein in the shadow banking system, forcing it to assess risk better, and become
more stable. The growth of private enterprise is important if China is to continue catching
that mouse, but where can the capital come from if loan growth is restrained and credit
realities are being brought home to the shadow banks and their clients?
The offshore yuan market has always been part of Chinas answer for capital needs as it
attracts capital by making the renminbi an international currency, stealing some of the
dollars thunder. If people are happy to leave their money, earning interest, denominated
in renminbi in Hong Kong and other centers then the Chinese would always have a
source of capital that could be tapped when it was needed. The project has been a
dramatic success, perhaps too successful as the carry trade brought a flood of money to
shadow bank deals. To stop this, the renminbi was allowed to fall about 3%, forcing
losses on these investors and hurting the banks. At the end of last week, something
changed. The market turned as the Peoples Bank of China set its dollar rate sharply
lower two days in a row. Now the PBoC, looking to revitalize the carry trade, will drive
money into the shadow banking system. By using foreign money, China is mimicking
the USs exorbitant privilege. having the rest of the world finance their economy. Look
for the CNH and CNY to reach new highs, as one hungry cat starts purring again.

FX CONCEPTS FX CONCEPTS
GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH
CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


CURRENCY Europe Long-Term View

Then and Now
By John R. Taylor, Jr.
_____________________________________________________________________________
About seventeen years and a few months
ago, the dollar started a multi-year
uptrend against what were the
component currencies of the euro.
Between the start of 1991, the depth of a
US recession, and late 1996, the dollar
had bounced back and forth in a
frustrating range that seemed to defy
analytical efforts. Only the Sterling crisis
and the European aftershocks seemed to
focus the market temporarily, until early
1995 when the US rescue of Mexico
seemed to spur a dollar sell-off and
clarified minds again. By the first half of
1996, back in whipsaw territory except for a very strong USD/JPY, no one saw any value
to currency overlay or currency prediction / directional management. I remember it well.
It was the printing of money to rescue Mexico, the Fed compared to the Bundesbank,
and Clinton for four more years that would keep the dollar down forever. A big heavy
equipment manufacturer, eating his European competition alive with the 'weakish' dollar,
fired us despite our (barely) positive performance over the previous four years. In the
next four years their pension under-performed and the European competitors came back
strong.

Back then the fundamentals were dollar positive. Germany was "the sick man of Europe"
and the US was growing more, its deficit dropping faster, and its interest rates were
higher than Germany and the future core. Today it's the same, except all of Europe is
sick outside of the UK and Norway. The pre-euro high of 1991 matches the euro high
of 2008, but since those highs the trajectories differ. Back then, the pre-euro
rallied with the Sterling crisis and the Mexico rescue standing out, but its general
trend was up. The driver was convergence. After the Sterling crisis was history, the
spread tightening as the euro kick-off neared brought money onto the continent. By early
1997, the game was basically over as the spreads were too tight for speculators and the
dollar began to strengthen more and more. This time around, the spreads began to
tighten after Merkel, the Bundesbank, and Draghi engineered Berlusconi's departure, but
the EUR/USD only joined after Draghi's bumblebee speech. Now the sovereign spreads
are almost as tight as they will go, so we find ourselves in the equivalent of late 1996 or
early 1997.

In the very major timeframe view, the euro is not only at its multi-decade peak but it is a
lot weaker than it was at the last peak. The major tightening cycle reaches its extreme
from Draghi's July 2012 this October, but from the Berlusconi ouster it has seen its
bottom. Net-net there is no more juice in that trade and it will be less and less a factor.
The short-term cycles call for the EUR/USD to drop to 1.3350 before month-end,
followed possibly by a rally to a late August high. If we reach 1.3350, the odds do
not favor a further high. The longer picture looks for 1.2100 and eventually below
the 2002 low.