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Conclusion: Fed-sponsored global inflation has led to China raising interest rates, which may lead to incremental monetary policy hawkishness by other central banks as nations from Asia to Latin America struggle to balance combating inflation with curbing currency gains. We could potentially see global interest rates chase China higher, effectively setting up for an end to the current cycle of dollar-debased reflation.

For the first time since 2007, China raised its benchmark lending and deposit rates: +25bps each to 5.56% and 2.5%, respectively. The move, which came as a surprise to many investors (who may have been preoccupied with the busy day of U.S. corporate earnings – BAC, JNJ, GS, etc.), should not be taken as a shock considering the inflationary data out of China of late: 

  • Property prices rose +50bps MoM in September – the first MoM gain since May
  • CPI accelerated to a 22-month high to +3.5% YoY in August – 125bps greater than China’s one-year benchmark deposit rate prior to today’s rate hike
  • The Shanghai Composite has rallied +27% from its July lows – overnight JPMorgan Chase & Co. and Citigroup raised Chinese stocks to “neutral” from “underweight” after the rally 

Today’s rate hike was both a direct response to the aforementioned inflation data and a proactive attempt at addressing the likely inflationary economic data to be released tomorrow. In an ironic twist, however, the rate hike could spur accelerated capital inflows into the country, which contributed to a record $194 billion increase in China’s foreign exchange reserves last quarter.

For the time being, China has chosen to aggressively combat inflation, given that ~36% of its citizenry lives on less that $2 per day (PPP), according to Asia Development Bank. To drain the excess liquidity that is bound to grow with additional capital inflows, the People’s Bank of China is prepared to step up its selling of bills, having already sold a net 209.7 billion yuan YTD after redeeming a net 579.5 billion yuan in 2009.

Elsewhere around the globe, we are seeing a directional shift towards hawkish commentary out of Asian and Latin American central bank presidents, many of whom are in similar predicaments as China: curb currency appreciation to remain export competitive or fight inflation to remain in power. Should this latest tone gain momentum internationally, we could see more central banks abandon the “currency war” and take a firmer stance on the inflation that has proliferated globally due to Fed-sponsored dollar weakness. A few of the notable quotes over the previous 24 hours are listed below: 

  • Australia’s central bank, led by Glenn Stevens, on setting the tone for another rate hike by year end: “The case to wait before making a tightening move was that… the rise in the exchange rate would, if it continued, effectively be tightening financial conditions on the margin.” With China raising rates, the long-Aussie trade may come under pressure, effectively heightening the probability of a subsequent Australian rate hike.  The Australian dollar is down around (-2.1%) today – the largest decline of all major currencies.
  • Thailand’s Finance Minister Korn Chatikavanij on being comfortable with a strong Thai baht: “We became manufacturers of goods to the rest of the world using our relatively cheap currency. That era is over and it’s over rather quickly, so very quick restructuring and rethinking needs to take place.”
  • South Korea said today that it is preparing additional measures to counter the inflows of capital that have been triggered by low rates overseas.
  • Brazilian Finance Minister Guido Mantega after raising taxes on foreign inflows for a second time to 6% from 4% said: “The currency war needs to be deactivated. We have to reach some kind of currency agreement.” 

In addition to inflation across various asset classes, the prospect of QE2 is creating chaos globally. Fortunately for the sake of sanity, central bankers the world over are starting to declare, “enough is enough”. The line in the sand is being drawn on Fed-sponsored dollar debasement. As we have warned over the last several weeks, don’t be on the wrong side when the reflation trade stops working – IF it already hasn’t begun to unwind.

Darius Dale

Analyst

China Raises Rates... Setting Off a Chain Reaction That's Bad for Reflation - 1