Sometimes, it is helpful to take a step back and obtain the Big Picture perspective. The following article was largely borrowed with permission from my favorite trader in Chicago. His previous life experience was one of a bond trader in the pit of the CME where — I am not making this up — he met Michael Jordan in person as Michael was visiting the floor and my buddy was in the middle of a call with China and could do nothing more than stick out his hand for Mr. Jordan to high-five.
The year was 1992 and the British pound was on a rally that started in 1985. But there were a few problems looming. First off the British economy was entering into a recession. Normally the Bank of England would have started an easing program by cutting interest rates. But due to a peg of the Sterling to the European Exchange Rate Mechanism, i.e. German Deutschmark, cutting interest rates was not an option. This forced the BOE to support the Sterling through market intervention to keep the peg to the Deutschmark. Giving some history, in October of 1990, Britain signed up to join the ERM. This would guarantee the British government would follow an economic and monetary policy, preventing the Sterling from fluctuation by more than 6% against ERM currencies. When Britain entered the ERM the Sterling/D-Mark was 2.95. But inflation in Britain was about three times that of Germany and the British economy was faltering. The Germans were in the process of reunification and began to raise interest rates to combat their own inflation issues. This forced the BOE to raise interest rates as well and use reserves to support the Pound. When it became apparent this level of intervention and high interest rates were strangling the British economy, investors and speculators began to sell massive amounts of Sterling, forcing the BOE to deplete more reserves to keep the Pound in the range against ERM currencies.
On Sept. 16, 1992, the BOE announced an interest rate hike from 10% to 12% with a promise to raise the rate to 15%. This was done to persuade investors to buy Pounds. That evening the Chancellor of the Exchequer announced Britain would leave the ERM and interest rates would remain at 12% but the next day they were lowered to 10%. What followed is now known as Black Wednesday (conservatives in Britain call it Golden Wednesday as they were thrilled to leave the ERM, paving the way for an economic revival).
Why is the above important? In a simple one-word answer, China. Currently the Peoples Bank of China is fighting with all its strength and breath to maintain the Yuan peg to the U.S. dollar. This is forcing the Chinese government to keep interest rates at high levels despite a weakening economy. The PBoC is also using foreign reserves to support the Yuan against a strengthening U.S. Dollar. Foreign reserves in China have now fallen below $3 trillion, from a high of $4 trillion. Putting this into perspective, $3 trillion is bigger than all the world economies other than the U.S., European Union, China, Japan and Germany. But the drop of over 25% in 2 ½ years is alarming and unsustainable. Combine this with $740 billion in assets leaving China over the first 11 months of 2016 and China being the No. 1 trading partner with over 100 countries, there are a lot of holes to fill. Yogi Berra would have suggested this is déjà vu all over again. Recently the Chinese government has tried to stem the flow of money leaving the country but as always when there is the will money will find a way to leave. Adding another load of weight to the problem is the trillions of dollars of bad loans Chinese banks are sitting on, nobody knows the true number. So far these banks have dealt with this issue by rolling over bad loans by adding new debt. Over the past 18 months credit in China has grown by $6.5 trillion, while total deposits have grown by less than 50% of that number. Currently there are rumors and talk of the PBoC ceasing their support of the Yuan. I have not seen or read anything official from the government regarding this so I greet this talk with skepticism. But it does make me wonder what happens to Chinese commodity buyers, specifically soybean crushers.
Back in August of 2015, the PBoC shocked everyone when they allowed the Yuan to devalue by 5.7%. This punished importers as the cost of goods increased instantly. The question becomes, if the Chinese crushers are told by the government or sense a lack of intervention from the PBoC supporting the Yuan, will we see an increase in soybean buying as a currency hedge? So far buying has been normal with crush margins slipping. I have not seen soybean buying that would support the theory stated above, yet. But we need to closely watch soybean buying, the Yuan, and any hints or statements for the Chinese central government. At some point China may have their own Black day.
Parlay his thoughts into the pork market and you may reach a similar conclusion. The price of pork in China is above what it was at this time last year. Last year saw record imports of pork to China — mainly from the EU. Could this be what has been supportive of the pork complex when our Hogs and Pigs Report would certainly indicate no shortage on the supply side? Our contacts with “Smart People” do not validate this hypothesis, but when markets do not follow their prescribed path of fundamental analysis you have to look somewhere for answers. The currency situation is probably a much larger issue than I am able to wrap my head around. Maybe there is some merit in considering this as a possibility.
The USDA grain report this past week was relatively lackluster. Nothing fundamental to get you too motivated one way or the other. We did, however, attempt to take December corn to $4 on Friday before it failed at that level. Seems that money flow, not fundamentals, will be the driver of the grain market as we are in a comfortable equilibrium on the balance sheets.