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MACRO: An Employment Gong Show

THIS WAS ORIGINALLY PUBLISHED ON JUNE 4, 2010.  REAL-TIME MACRO CONTENT IS AVAILABLE TO RISK MANAGER SUBSCRIBERS.

 

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Conclusion: Employment “growth” is anemic and looks weak going forward, which will be a negative catalyst for equities.
 
Today’s underwhelming Employment report was no doubt made worse by Goldman Sachs Chief Economist Jan Hatzius’ lofty forecast of +600,000 payrolls for the month of May (a +100,000 increase from his previous estimate). While being “a little low on the census contribution” was his chief reason for upping his forecast far above the median consensus estimate of a 536,000 gain, our Hedgeye estimate was that he (and consensus) was “a little too high” on the private contribution. Jan’s estimate was for an incremental 150,000 private payrolls to be added in May vs. 180,000 consensus.
 
Private payrolls added for the month of May was reported at an anemic 41,000 – first marginal deceleration since December of 2009. After a 9% drop in the S&P throughout the month, and a near 11% drop from the highs of April to the end of May, it was proactively predictable that the rate of job growth would slow on the margin. For clarification, the S&P 500 and Net Private Payrolls have a 0.72 positive correlation over the last three years. That’s an r-squared of 0.53, which suggests some level of statistical significance.
 
Interestingly, if we normalize for the birth-death adjustment, which we admit is the fodder of conspiracy theorists, and exclude the 215,000 birth-death adjustment, the economy actually lost 226,000 jobs.  Even if you aren’t willing to accept that dire of a claim, those unemployed longer than 27 weeks hit a new record coincident with this report at 46%.  The likelihood that people just give up hope and drop out of the workforce increases every week with that statistic.
 
We shorted the QQQs into the close yesterday based on the view that this payroll number was going to be worse than expected.  While Hatzuis’ took the shot, and we admire him for that at least, by inflating the whisper consensus number, he actually increased the probability that we would be right on our short call and that payroll additions would be worse than expected by implicitly increasing consensus expectations.
 
While consensus hiring is boosting over all payroll additions and, temporarily, decreasing the unemployment rate, this payroll report should be framed for exactly what it is . . . a disaster.  As we’ve highlighted in the chart below, this is a sequential decline in the addition of private sector jobs and highlights two critical points: a) this is a jobless recovery at best and b) the stimulus package has failed to stimulate any real sustainable jobs additions.
 
With the stimulus behind us and census hiring also primarily in the rear view mirror, it is likely that the payroll additions will continue to be anemic, and that the actual unemployment rate ticks back up.  And that, as they say, is not good.

 

 

MACRO: An Employment Gong Show - Screen shot 2010 08 11 at 6.47.34 AM

 


Daryl G. Jones
Managing Director
 
Darius Dale
Analyst


MACRO: HOUSING IS STRUGGLING COMING OUT OF...

This insight was originally published on May 28, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF THE POST-EXPIRATION BLOCKS

 

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Housing Datapoints Emerge Suggesting the Post-Tax Credit Expiration Decline Has Begun
We had theorized that housing would drop significantly after the tax credit expiration in April, as it did following November's tax credit expiration, and now we're getting early data to confirm that view. Yesterday, the herd drove housing-related equities modestly higher on a strong New Home sales print and Bob Toll's upbeat commentary. This was in spite of surprisingly high (and rising) existing home inventory and falling home prices (see our notes from Monday and Tuesday). The reality, however, is that since the end of April, demand in the housing market have been deteriorating.
 
The following chart shows MBA Mortgage Purchase applications indexed to 100 on January 1, 2010. On this basis, average applications in March were up 13.8% from the start of the year, and average applications in April were up 23.2% from the start of the year. In the first 3 weeks of May, however, applications were down 14.4% from levels in April. More striking is the fact that the most recent datapoint - May 21 - is down 25.6% from the average April level. Here's what the MBA's chief economist had to say following the release of the 5/14 data:
 
Purchase applications plummeted 27 percent last week and have declined almost 20 percent over the past month, despite relatively low interest rates. The data continue to suggest that the tax credit pulled sales into April at the expense of the remainder of the spring buying season. In fact, this drop occurred even as rates on 30-year fixed-rate mortgages continued to fall, and at 4.83 percent are at their lowest level since November 2009.
 
By the way, the week after the above comment was made - 5/21 - was the lowest weekly mortgage purchase application volume week since 1997. It's an interesting theoretical question to ask whether volume was down because of the pull-forward, the sharp stock market correction or a combination of the two.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 1

 

 

The next chart shows Toll Brothers sequential change in buyer traffic from April to May. Bob Toll's comments in the quarterly earnings release yesterday were very positive, generating understandable investor enthusiasm towards not just TOL but the whole space. See Bob's comments below.
 
It appears our business has finally emerged from the tunnel and into a bit of daylight. For the third consecutive quarter, our signed contracts per community exceeded both of the previous two years' comparable-quarter totals. Deposits and traffic per community have been trending positively for the last four-, eight- and twelve-week periods. And our conversion percentage rate from traffic to deposits (non-binding reservations) was the highest second-quarter total since we began tracking this data in 1994. In the three weeks since the start of our third quarter on May 1st, which coincided with the expiration of the homebuyer tax credit, our per community deposits and traffic were up 23% and 11%, respectively, over last year's comparable period. May's activity suggests that for us the tax credit wasn't the determinative factor – rather, we believe, the past few months' activity has been driven by an increase in confidence among our buyers in their job security, their ability to sell their existing homes, and general trends in home prices.
 
One important fact check supplied during the Q&A portion of the call, however, revealed that year-over-year growth in buyer traffic - traffic is among the best leading indicators for housing - actually declined by two-thirds in May vs April. See the chart below. The +11% yoy May increase in buyer traffic cited in the release actually compared with a +25-30% increase in April. Suffice it to say that in spite of their claims, Toll is seeing a marked slowdown in activity following the tax credit expiration.
 
It's also worth pointing out that Toll Brothers houses are not representative of the country. For reference, their average ticket is in the $700,000-725,000 range, which puts them right at the cap of conforming loan limits: $729k for the highest priced markets. Considering Fannie and Freddie together accounted for over 95% of all mortgages issued last year, we would submit that the Toll Brothers addressable market does not reflect demand trends for better than 90% of the housing market.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 2

 

 

One striking consideration is that mortgage rates are at incredibly low levels. The 30-year conforming mortgage went out at 4.86% last night, down from a recent peak of 5.25% on April 4. The following chart shows average mortgage rates by month and for quarters going back to the start of the year. The drop in mortgage rates in May is striking. May is down 19 bps, on average, vs April. While the current rate of 4.86% is down 24 bps from the average April rate. In spite of this, purchase applications just posted their lowest reading since 1997.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 3

 

 

The bottom line is that May data is starting to trickle in and so far it is very weak. We don't think the market yet appreciates how weak this May data is, but it will figure it out soon enough. In the interim, we offer the following chart that we published recently showing lenders stacked in order of relative exposure to residential real estate by combining residential first lien mortgages, second lien mortgages, HELOCs and 1-4 Construction loans. We think that as the market shifts its focus from the EU and Financial Reform to the worsening state of the housing market this summer it will put pressure on those companies with the greatest credit exposure to housing.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 4

 

 

To summarize, here are the negatives on housing at the moment:

  1. May purchase applications are at a record low.
  2. Toll Brothers traffic index goes from +25-30% yoy in April to +11% in May.
  3. April existing home sales data showed a ballooning of inventory (a leading indicator) in spite of a rise in sales.

And here are the positives:

  • New home inventories are very low.

We think the negatives pretty clearly outweigh the positives here, and we would recommend caution for longs and bearishness for those with short capabilities on all companies with a high degree of sensitivity to home prices heading into the back half of this year.
 
 
Now for the silver lining
The April New Home sales data out yesterday was really exceptionally strong, as one would expect in the final month before  tax credit expiration. Sales came in at a 504k annualized rate, +22.6% from the prior month and up 46% from the year earlier, and way above consensus. There's no debating that this was an exceptionally strong result. Moreover, inventory of new homes is down a lot. From a units perspective, new home inventory is reported at 211k, down almost 8% from last month's 229k print. The equally important months supply calculation fell to 5.0 months, down from 6.7 months last month. This had more to do with the huge pickup in sales activity than it did with the decline in inventory, but nevertheless the months supply reading for April was very strong.
 
The catch is that unlike existing home sales, which measure contract closings, new home sales measure contract signings. In other words, while we'll continue to see existing home sales prints rise for the next two months (a lagging indicator), for new home sales April was it - the end of the good prints. We're now on the backside of the tax credit expiration. If inventories weren't so low we would be bearish on the homebuilders. We expect competitive pressure from the existing home market to weigh on new home sales volume and pricing. That said, the low inventories make the short case quite  challenging. We'll have to wait and see how the new home market evolves.
 
The following are several charts related to new home sales that we think tell the story of this month's data.
 
As mentioned before, new home sales were exceptionally strong in April.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 5

 

 

Inventories also fell considerably.

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 6

 

 

From a longer-term perspective, inventories on a units basis are at all time lows, while on a months supply basis, they are near their lows.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 7

 

 

We include the following chart more as a reference point. It shows the share of total home purchases represented by new homes. The chart would suggest that the new home sales share is quite depressed by historical standards, and the more likely of the two outcomes would be for some degree of mean reversion to kick in. In other words, it would seem more likely than not that new home sales would gain share from here than that they would lose share. That being said, the world has changed in the last few years and we're still unclear on the extent to which things are going to go back to business as usual. As such we're still cautious in assuming that this penetration should bounce right back to 14-16% - a common refrain from investors long the builders.

 

 

MACRO: HOUSING IS STRUGGLING COMING OUT OF... - Chart 8

 

 

 

Joshua Steiner, CFA
Managing Director
 
Allison Kaptur

Analyst


MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED...

This insight was originally published on June 22, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED SETTING STAGE FOR WORSE DOWNTURN

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THE BOTTOM LINE
May existing home sales were much worse than expected in spite of the continued effect of the April 30 tax credit expiration pull-forward. May sales came in at 5.66 million (seasonally adjusted annualized rate) down from 5.79 million in April (revised a tad from 5.77 million). Expectations were for sales to rise north of 6.2 million units. Sales coming in 9% below expectations reflects a major incremental negative datapoint.
 
Summary
Remember that this May print is a lagging indicator as it reflects deals closed two to three months ago (Mar/Apr) because of the 30-60 day lag between signing and closing.
 
In our view, the relevant benchmark is how it compares with October 2009's print of 5.98mn. Against that measure, it's down considerably (5.66). The original tax credit expired in November, 2009, putting October 1 month ahead of that expiration. The current credit (for closing) expires June 30 (April 30 for signing), which means 1 month ahead equals May.
 
In other words, it's now clear that tax credit round two is having a less substantive effect on sales than round one did back in late-2009.

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 1

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 2

 

 

Inventory, on a units basis, fell a modest 3.4% to 3.89 million units from 4.04 million units in April.

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 3

 

 

Inventory, on a months supply basis, fell slightly to 8.25 months from 8.4 months last month. While inventory is down nominally on a months supply basis, this is somewhat misleading because its keying off an artificially high May 2010 sales rate. If we assume that the same dropoff in sales occurs following this tax credit expiration as followed the last tax credit expiration we can expect to see a sales rate of 4.25-4.5mn a few months from now. Meanwhile, inventory is at 3.89mn units. In other words, inventory could rise to 10-11 months or higher very shortly.

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - Chart 4

 

 

Our view is that this pull forward of activity is setting the stage for a much weaker-than-usual summer housing environment. Housing-sensitive stocks could be at risk heading into the 2H10 and 2011 time frame.
 
We have an extensive report coming out on this topic on Friday for subscribers and prospects of our Financials Vertical, which we will summarize on a conference call at 11am on Friday.
 
 
Joshua Steiner, CFA
Managing Director
 
Allison Kaptur
Analyst


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MACRO: The End of Quantitative Easing...

This insight was originally published on April 8, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS subscribers in real-time.

 

 

MACRO: The End of Quantitative Easing, As We Know It

 

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“It’s the end of the world as we know it and I feel fine.”
-R.E.M.
 
R.E.M. is an iconic American rock band that was founded by Michael Stipe in 1980.  While the band is not known for its thoughts on monetary policy, the line quoted above from their song, “The End of the World Was We Know It”, provides a good metaphor for the Federal Reserve’s recent decision to halt quantitative easing.
 
While many market observers expected this planned ending of policy to lead to an increase in interest rates, particularly for mortgages, we have seen only a marginal change in rates.  In fact, over the last three weeks 30-year fixed mortgage rates have only increased marginally from 5.05% to 5.25%.  In essence, the quantitative easing world has ended, but those still borrowing via mortgages “feel fine”.
 
To its credit, the Federal Reserve did an effective job at prepping the market for the end of this policy, so new buyers stepped in and the mortgage market has remained stable.
 
Backing up for a second, though, what exactly is quantitative easing?
 
Central Banks have basically two key tools to implement monetary policy:  interest rates and reserve requirements.  By lowering interest rates, central banks can stimulate money supply by making borrowing rates more reasonable to borrowers and the margins from lending more compelling to lenders.  On the reserve front, the central bank can alter the reserve requirements, which is the ratio of cash a bank must hold compared to customer deposits. Any increase in reserve requirements will limit a bank’s ability to lend, or vice versa.
 
In the scenario where the interbank interest rate is zero and reserve ratios have been maxed out, central banks can initiate another form of policy: quantitative easing.  In simple terms, central banks will begin to purchase financial assets from banks through open market operations.   So the central banks print money to buy assets from banks, which increases the excess reserves on the balance sheet of banks.
 
Quantitative easing was used by the Bank of Japan in the early 2000s in an attempt to offset deflation with limited results.  In November of 2008, the United States implemented their first ever policy of quantitative easing.  The policy had two aspects to it.  First, the Federal Reserve indicated they would purchase direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Second, the Federal Reserve indicated they would purchase mortgage back securities.
 
The objective of this program according to the Federal Reserve was to, “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”  In effect, as credit markets ground to halt in late 2008, the Federal Reserve had to take the extraordinary and unprecedented measure of quantitative easing to offset the potential risk of deflation.
 
While the program started on a smaller scale with $500 billion of mortgage backed debt, the program was increased in March of 2009.  As the program ended on March 31, 2010, the Federal Reserve had purchased $1.2 trillion of mortgage-backed debt from banks and $200 billion of direct obligation debt of Fannie Mae and Freddie Mac, for total purchases of $1.4 trillion.  As a result of these actions, the Federal Reserve now owns almost 25% of the stock of mortgage-backed securities.
 
In the chart below, we have charted the increase of excess reserves on bank balance sheets.  The current amount of excess reserves is estimated to be around $1.2 trillion.  Assuming that these excess reserves were turned into loans at a 10:1 ratio, the increase in money supply into the system would be $12 trillion.  This is larger than the current amount of outstanding mortgages in the United States!
 
The reality is simply this: we have no idea what the consequences of this quantitative easing policy action will be.  It is an unprecedented move that, in time, will have to be unwound.  If the unwinding is natural, which would involve banks reducing their excess reserves to a more normal level, the inflationary impacts on the U.S. economy could be extraordinary.
 
At this point, I’m not going to predict the “end of the world as we know it” due to this massive increase in excess reserves, but this policy will have to be unwound at some point.  Either the Federal Reserve will have to pay competitive interest rates on these reserves so as to discourage loans, or the banks will begin to lend.  And lend.  And lend.
 
I can promise you this, if the $1.2 trillion in reserves starts to make its way into the economy, money supply will increase dramatically, and with it, inflation.  While there is increasing discussion of inflationary pressures, very few people are currently considering the unintended consequences of quantitative easing.

 

 

MACRO: The End of Quantitative Easing... - Chart 1

 


Daryl G. Jones
Managing Director


MACRO: Watching the IRS

This insight was originally published on May 12, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

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Conclusion: Keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year, and for it to be priced into the markets as early as this summer.

 

With sovereign debt concerns, the EU bailout package, accelerating inflation, and fat fingers garnering so much investor attention globally, we thought  we'd give you a quick global macro break and focus you on a domestic issue that will become increasingly important as 2010 progresses - 2011 tax hikes.
 
Since I collected my first paycheck some 8-9 years ago, I've been duly focused on taxes - i.e. how much of the money I made I wasn't actually going to be able to spend. After all these years (joke), the only thing I've come to learn about taxes is they don't get less annoying with time. And in 2011, I expect to become even more annoyed (along with a lot of other taxpayers).
 
Changes to be enacted in 2011:

  • Income tax brackets are scheduled to change for 2011, with the highest rate increasing from the current 35% to 39.6%. Each of the lower brackets will also be increasing. It has yet to be determined where the income threshold will be for each bracket, but taxpayers can rest assured that their federal tax burden will be increasing for 2011;
  • Capital gains tax rates are also scheduled to change. The top rate for long-term capital gains is expected to rise from 15% to 20%; and
  • The preferential qualified dividends tax rate of 15% is scheduled to expire, so all dividends will be taxed at ordinary income tax rates.

Obviously, this will be a headwind for the American consumer and will have negative implications for discretionary spending in 2011 (we may see a marginal pull-forward in spending on larger-ticket purchases this year as consumption is all but sure to decline next year). Less obvious, however, are the implications the tax rate hikes will have on the certain markets and M&A activity.
 
Under the new tax structure, we could see investment money flow towards capital gains away from equity income - especially those monies that will be taxed at or near the highest rate (39.6%). With so many retirees dependent on dividend funds, however, Congress may be inclined to level the playing field by either raising capital gains taxes or lowering the tax rate on dividends. Time will tell on that matter.
 
The far right column of table below shows the Y/Y percentage change in the after-tax income from a variety of investment sources. We have used the top tax bracket as a proxy for wealthy investors, simply because the flow of their monies will have greater impact on the overall investment community.

 

 

MACRO: Watching the IRS - Chart 1

 

 

It is important to also note that municipal bonds and municipal bond funds will become more attractive on the margin vs. taxable bonds and taxable bond funds. While we believe the state budget and U.S. sovereign debt issues will have a greater impact on municipal bonds inflows, we'd be remiss not to call out this additional tailwind for the investment vehicle.
 
Regarding M&A activity – which should pick up with capital gains taxes headed higher – private businesses will be looking to sell prior to the tax rate hikes, and, as the year progresses, those looking to acquire with cash will have a more favorable environment. Sellers will certainly feel the pressure to unload by year's end rather than face a 33.33% higher effective tax rate in 2011. Aware of this selling pressure, buyers equipped with cash will be hunting for discounts late in the year. As an aside, buyers looking to acquire with deferred payments may be subject to a premium to offset the seller's increased 2011 tax burden.
 
In short, keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year and for it to be priced into the markets as early as this summer.
 
Darius Dale
Analyst


MACRO: Is the Yuan a Yawn?

This insight was originally published on June 21,2010.  MACRO Intraday updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

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Conclusion:  The potential revaluation of the Yuan is positive for Chinese equities, but likely negative longer term for Treasuries.  It will also benefit the currencies of those nations that supply basic materials to China – Australia, New Zealand, Canada, and Brazil.
 
The global macro news of the day is, of course, the statement by the People’s Bank of China that they are going to end the two year peg of the Chinese Yuan against the U.S. dollar.  The timing is apropos as the G20 Summit is occurring this coming weekend in Ontario, and increased pressure on the Chinese to let their currency more freely float was very likely.  At the least, the Chinese have bought themselves time in that debate, though it does seem likely that this is the first step in a more freely floating currency.
 
Per the release from the People’s Bank of China:
 
“The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.”
 
While this announcement is certainly bullish for the Yuan, it must be taken with a grain of salt as it doesn’t dictate a revaluation of the Yuan or even a change in the daily trading range, but emphasizes flexibility.  So, in effective, it was the bare minimum in terms of policy to support a Yuan revaluation.  Clearly, though, with increasing signs of inflation within China, this is a way to dampen housing and consumer price increases that threaten the Chinese economy.
 
So far the reaction from the U.S. government has been muted at best.  Treasury Secretary Timmy Geithner released a statement yesterday in which he stated:
 
“This is an important step, but the test will be how far and how fast they let the currency appreciate.  Vigorous implementation would make a positive contribution to strong and balanced global growth.”
 
Translation: Timmy likes this, but he wants to see more action.  While obviously Timmy’s statement may be politically convenient within the confines of the domestic U.S., Chirping Our Creditor has implications in its own right, specifically as it relates to the appetite of the Chinese to continue to fund U.S. deficits.  Moreover, a revaluation of the Yuan will fundamentally lead to lower demand for U.S. Treasuries over the long run.
 
The longer term impact of this change in policy will likely be a decreased demand for U.S. dollars.  In order to maintain the fixed exchange rate with the U.S. dollar, the Chinese government had to get long of the U.S. dollar.  Their method for doing this was to purchase U.S. Treasury bonds in large sums.  With the decision to let the Yuan float, the need to purchase U.S. dollars decreases and with it, on the margin, Chinese demand for Treasuries, which will be negative for the price of Treasuries (and positive for yields).  The chart below outlines this point as it shows that Chinese purchased more than $450 billion in U.S. Treasuries over the last two years, while the currencies were pegged, which was almost the same as the prior eight years combined.
 
So far this morning, the movement in the Yuan has been a bit sleepy.  With no specific policy action, the Yuan is still confined to its 0.5% daily trading range.  That said, even as this announcement is somewhat rhetorical in the short term, the long term implications are positive:
 
1)      It is indicative of the Chinese showing a willingness to play by the rules of free and open markets, which will increase confidence in investing in China
 
2)      The potential of trade wars will be somewhat alleviated on the margin as the argument that China has a structural competitive advantage due to an undervalued currency is less compelling
 
3)      A stronger Yuan will combat internal inflation within China, which offsets a key potential risk for the global economy – an overheating of the Chinese economy followed by a dramatic decline (think POPPING of a bubble)
 
As it relates to global trade, a more highly valued Chinese currency will increase China’s purchasing power for commodities, which are priced in U.S. dollars.  Therefore as the Yuan appreciates, it will have positive fundamental impacts for those countries that sell commodities into China. Think Australia, New Zealand, Canada, and Brazil.  Not surprisingly, the currencies of these nations are acting accordingly and are up between 0.75% and 1.00% across the board today (with Brazil up a little less).
 
While the movement in the Yuan today may be a bit of yawn, the longer term implications of a meaningful revaluation will have a real investable impact on various asset classes globally. And positioning for this revaluation will be critical.

 

MACRO: Is the Yuan a Yawn? - Chart 1

 

 

Daryl G. Jones
Managing Director


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