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What To Do as Yuan Revaluation, Quantitative Easing Programs Repeat

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Ignore China's various interest rate hikes and watch for QE3.

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If you are of a certain age, and I certainly am, you remember when Hollywood pretended its retreads and sequels were not as half-baked as everyone knew they were. The blockbuster Hog Jaws Attacks would be followed by something called Trough Trouble, not Hog Jaws Attacks II.

But now we debate QE3 before QE2 has been laid to rest, which raises the real possibility Ben Bernanke might approach the 12 entries in the Friday the 13th franchise, all without the benefit of those occasional visuals that make teen horror flicks memorable.

Unremarked in all of this is the role the second revaluation (RV2, thanks for asking) has had in US financial markets over the past year. RV1, for those of you keeping score, was the first Chinese move toward revaluation in July 2005. This ended in July 2008 when the Chinese learned all those Fannie Mae and Freddie Mac securities they were buying had the full faith and credit of a box of Cracker Jack, not of Uncle Sam. That led Hank Paulson to extend the Treasury's guarantee to the agencies; the world almost died two months later.

Let's now return to an analysis from February 2010 on the role of Chinese money-market conditions play in US fixed-income markets. Briefly, China needed to buy US securities to maintain the yuan peg. China was preparing for yuan revaluation at the end of March 2010, the time when QE1 was set to expire, but the move was delayed by the Greek sovereign credit crisis. Part of this preparation was lower purchases of US securities at a time when the Federal Reserve was printing less money; stocks responded by selling off in May-June 2010 and bonds commenced a major rally into the start of QE2 in November.

RV2 began in June. The yuan's forward rate ratio between six and nine months (FRR6,9) -- the rate at which we can lock in borrowing for three months starting six months from now, divided by the nine-month rate itself -- collapsed. The US waited a month and then began acting as low short-term interest rates were not low enough: QE2 would follow RV2, and the USD FRR6,9 steepened.

Money Market Chart

Once the money started rolling in, Argentina-style, with the start of QE2 in November 2010, the extra liquidity propelled stocks higher. It also propelled inflation expectations and bond yields lower.

Treasury Yield Chart

Where does this leave us? The answer is two-fold: First, you can ignore China's various interest-rate hikes and credit-tightenings; what matters is the speed at which the yuan will be allowed to revalue. For US stocks, slower is better. Second, watch for QE3. If we get it, say bye-bye to bonds and hello to further stock gains. If not, bonds will perform relatively better vis-à-vis stocks than they have over the past four months.

It is all a theatrical production; the world is a stage and we are but actors in a string of sequels. When the good folks at various celebrity-gossip outlets start leaking news of QE3, make reservations for the stock-buying show.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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