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

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



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

Quantitative Guessing

This note was originally published at 8am this morning, October 19, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Time and persecution brings many wonderful things to pass.”

-George Washington


One of my thought partners here at Hedgeye is our head of everything compliance, Moshe Silver. In our final days of being paid by the establishment, we worked closely together at Carlyle. I’d manage daily P&L risk and he’d manage the risk surrounding how our hedge fund teams were driving that P&L.


Moshe writes a must-read Weekly Compliance Screed that we publish on Mondays to our exclusive network of clients. Yesterday’s was titled, “Qualitative Easing” and it was one of Moshe’s best. He provided the historical context for America’s present season of discontent by citing Ron Chernow’s new biography of George Washington.


This is as much a point about leadership than anything else. America’s markets are turning into the sort of soft and qualitative excuse making zones where losers find comfort and coddling. If you aren’t raising children you may not see this as clearly as the rest of us parents do, but this “no one loses” and “my little Johnny just wants to be happy” stuff is becoming pervasive in American culture.


What happens when little Johnny runs into a Chinese kid who crushes him like a bug? Should we call for a time-out and some quantitative easing? If Apple doesn’t beat on iPad sales, should we invoke the deflation Gods for QE3?


Moshe suggests that “today, the underlying issue is a total abdication of responsibility on the part of those invested with the Public Trust. The reason that it has become compelling as an ongoing policy matter to debauch the once-proud Dollar is that our society has established a pattern of behavior.”


“The rest of the world recognized US indebtedness as a nascent problem as far back as the early 1980s. Is it realistic for Washington (the DC kind) to push back on generations of excess? We search in vain for anyone in a position of Public Trust to take a stand against this madness.”


How about the Manic Media? Could its core competency in taking the sell-side’s word for missing virtually every crash until after it has occurred proactively protect Americans and their hard earned savings? Or does the financial media stand in awe of revisionist Big Broker analysts whose tongues lick the Greenspan grounds of taking academic dogma’s word for it?


This morning even one of the most admirable American media platforms fell into the trap of time and persecution. Bloomberg’s Ian Katz opened his review of Timmy Geithner’s currency remarks by suggesting that “a weak dollar may now be in the national interest.” Are you kidding me, man?


If you dig into the financial editorials this morning, Dartmouth’s David Blanchflower recaps his Groupthink Inc. sessions with the finger pointers of America. I couldn’t paraphrase this if I tried:


“I was at the Fed last week in Washington for one of its occasional meetings with academics. Half a dozen labor economists, including myself, met with Fed Board members to discuss the labor market. Of particular importance was a paper by John Haltiwanger, a professor of economics at the University of Maryland, who showed there has been a big decline in the job-creation rate over the past decade. The current obstacle is the lack of credit for small firms.”


Right, right guys. The “current obstacle”  couldn’t be staring you right in the mirror could it? It must be that banks aren’t lending. Right, right… back to debauching the currency then.


Who is going to stand against Quantitative Guessing during this political season? Who is going to stand up and lead? I think it might just be the Chinese. They are proactively RAISING interest rates this morning. Why? Take a wild and crazy guess. You got it Pontiac – QE2 is stoking the bonfires of global inflation.


Don’t ask Fed Chairman Bernanke to stand up for 43 MILLION Americans (the # of Americans on the Food Stamp program) have to put gas in their cars and, God forbid, eat. On Friday, Bernanke said that “we are still learning about the efficacy and appropriate management of non-standard policy tools that do not rely on interest rate deductions.”


In plain English, Americans need to know what that means. Like his predecessor at the Fed, Arthur Burns, who perpetuated Jobless Stagflation in the 1970’s by monetizing US Treasury Debt, Ben Bernanke has no idea how this is going to play out and he’s not allowed to say it could play out Japanese.


Ask a man you can trust – Moshe: “Bernanke is effectively saying we haven’t quite gotten the knack of handling your money, but we are making progress. Another few TRILLION and we should really have it down to a science.” Like journeymen stock brokers and money managers who learn this craft by losing large quantities of other people’s money, those charged with managing the economy have resorted to Quantitatively Guessing…


As George Washington observed, if people are persecuted long enough by their government, they will change their behavior. And change is not a “crisis” until someone gets fed up with it all and punches your little Johnny’s qualitative whining in the face.


My immediate term support and resistance levels for the SP500 are now 1170 and 1186, respectively. On September 19th the cash position in the Hedgeye Asset Allocation model was 46%. A month later, on this fine day of defending ourselves (October 19th), we’ve raised that cash position to 64%.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Quantitative Guessing - QG


Conclusion: I expect 3Q EPS and guidance to be helped by the weak dollar but a sales rebound is necessary in Europe and APMEA to restore confidence after a poor August showing.  The US likely remained strong in September, up 5-6%, but I would expect trends to slow on a two-year average basis going forward as the incremental smoothie sales should fall off in the colder months.  As it stands today, 2011 is going to be a challenge for MCD, particularly as reported comparisons get increasingly more difficult come March.


Having covered MCD for nearly 17 years, I was struck by the retirement of MCD’s head of investor relations Mary-Kay Shaw.  Before Mary-Kay took the helm, Mary Healy sat in the hot seat during some very difficult times at the company, and she retired when the stock was in the mid-20’s; just before the company took off on this incredible run.   Mary Healy had an unfortunate sense of timing!  Perhaps the departure of Mary-Kay Shaw is a negative omen for MCD given the run the stock has been on and how difficult a year 2011 is shaping up to be.  The way I see it, Mary-Kay Shaw may prove to have a better sense of timing.


McDonald’s is scheduled to report its September sales numbers, along with its 3Q10 earnings results, before the market open on Thursday, October 21st.  September 2010 had one less Tuesday, and one additional Thursday, than September 2009.


Below I go through my take on what numbers will be received by the street as GOOD, BAD, and NEUTRAL, for MCD comps by region.  For comparison purposes, I have adjusted for calendar and trading day impacts.  To recall, August same-store sales numbers showed maintenance of trends in the United States and softness in Europe and APMEA. 



U.S. (facing a 3.2% compare, including a calendar shift which impacted results by -0.2% to +0.2%, varying by area of the world):


GOOD: 5% or greater would be perceived as a good result because it would imply that the company was able to improve U.S. two-year average same-store sales by ~15 bps on a sequential basis, when adjusting for calendar shifts, off of an already improved August trend.  This would be a strong number when compared to the results thus far in 2010, with only July coming with a higher number: +5.7% (albeit aided by a positive calendar impact of 0.4% to 1.3%, varying by area of the world). 


NEUTRAL: Roughly 4% to 5% implies two-year average trends that are approximately in line with those seen in August.  I would be disappointed to see a number in the low end of this range, however.


BAD: Below 4% implies that two-year average trends deteriorated on a sequential basis from August.  Given that the U.S. was the only market to maintain sequential two-year trends in August, it would be a bad sign for MCD if the U.S. market were to slow from here. 



Europe (facing a difficult 6.9% compare, including a calendar shift which impacted results by -0.2% to +0.2%, varying by area of the world):


GOOD:  A print of 2.5% or higher would be viewed positively because it would imply a sequential gain of ~100 bps in two-year average trends in Europe.  While this would be the lowest print of the year outside of August, it is worth bearing in mind that August’s 2.2% print was on the back of a 3.5% print in August 2009; September 2009 saw a jump in same-store sales to +6.9% in Europe.  A GOOD result in Europe would suggest that last month was a blip rather than a beginning of a more protracted malaise.  A significant acceleration in two-year trends from August’s soft result would likely be required to convince the street.


NEUTRAL: A result of 1.5% to 2.5% implies sequential trends held relatively level in Europe during September.  While even the low end of this range would imply a marginal increase in sequential two-year average trends, last month’s print of 2.2% was the lowest of the year. 


BAD:  Less than 1.5% would be the worst headline number since February 2009.  While a sequential slowdown in two-year average trends will be avoided unless comps slip below +0.45%, such a significant decline from August’s print would be disconcerting.  However, maintaining two-year average trends from August is not that encouraging either as it implies that the softness was not the result of a one-month issue.



APMEA (facing a 5.3% compare, including a calendar shift which impacted results by -0.2% to +0.2%, varying by area of the world):


GOOD: 4.5% or higher would imply a sequential increase of ~40 bps versus August.  Following August’s disappointing print, and declining two-year average trends, this would be a positive for investors.  While 4.5% is typically a low print for APMEA, September 2009 presents the most difficult comparison since May.  The May 2010 result was +3.8%, which translated into a 50 bps gain in two-year average trends. 


NEUTRAL: 3.5% to 4.5% would result in two-year average trends being maintained from their August levels. 


BAD:  Below 3.5% would imply a significant slowdown from the lackluster print in August and could raise investor concerns about MCD’s APMEA business.






Howard Penney

Managing Director

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Bull/Bear Battle: SP500 Levels, Refreshed...



If the SP500 closes below 1170 today, this selloff heightens the probability of my compressed-crash call.


As a reminder, I’ve been calling for a 33% chance of what I called “A Heavier Crash” on September the 29th. This email is by no means is meant to be a victory-lap. Probable doesn’t mean likely… but heightening probabilities need to be monitored, acutely.


So what would a Heavier Crash look and feel like? I’m in print saying that “the most probable scenario that the perma-bulls would consider improbable is a 1-3 day correction on the order of -5.4% to -6.9%.”


Notwithstanding the bad karma that’s associated with any October 19th (1987’s crash), there is a very high probability that a TRADE line breakdown through 1170 puts the 1144 line back in play on the downside. From yesterday’s 1184 close, that would be a -3.4% correction – not a compressed crash – but… and there’s always a but… there are still plenty of days left in October… and bad US housing data is on the docket for next week.




Keith R. McCullough
Chief Executive Officer


Bull/Bear Battle: SP500 Levels, Refreshed...  - 1

The Electoral Scorecard . . . Democrats More Secure in the Senate

Conclusion: While the House looks like a runaway for the Republicans, the Senate is looking more and more secure for the Democrats.


We noted, with interest, Mark Zandi's (from Moody's comments on Bloomberg this morning that, "Washington is the center of the economic universe." While we certainly do not believe it should be, it is the sad truth that the policy makers in Washington have inordinate impact on the markets these days, especially as it relates to the potential for further quantitative easing.  As such, we wanted to update our predictions heading into the upcoming midterms.


From a top down perspective, not much has changed for the Democrats.  President Obama's approval rating, according to the poll aggregate at Real Clear Politics, is effectively as low as it has ever been with a 44.7 approval rating and a 49.2 disapproval rating.  The negative spread is -4.5. The approval rating of the President has worsened over the last couple of weeks as he has hit the campaign trail and is likely to deteriorate further in the coming weeks as Republicans ramp up advertising spending.  As it relates to the outcome of the midterms, this is about as good a leading indicator for the results as there is when it relates to party preferences.


This strong aversion to Democrat candidates is also seen in the Generic Congressional vote, which polls generic preferences.  Similar to the President's approval rating this poll, also according to the Real Clear Politics poll aggregate, is at close to its worst levels as well.  Currently, only 41.2 percent of those polled prefer a Democratic candidate, while 48.2% prefer the Republican candidate.  This is a positive spread of 6.9 for the Republicans.  These preference are also underscored by a Republican base that is very motivated to vote during these midterms.  As we've previously noted, more Republicans than Democrats voted in the primaries than in any period since the Great Depression!


In the House, a Republican takeover is all but a foregone conclusion.  Currently based on district level polling, it appears that the Republicans will safely win 213 seats and the Democrats will safely win 179 seats.  The remaining seats, some 43, are currently considered toss ups.  The Republicans will only need to win 5 of the 43 seats that are toss ups to gain the 218 seats needed to claim a majority, or just over 10% of the toss ups.  Looking at the underlying momentum, of the seats that have recently shifted, 12 seats have shifted to the Republican side and only 2 have shifted to the Democratic side.  If those trends continue 37 of the seats currently considered toss ups could go Republicans, which would mean the Republicans would have 250 seats.  The last time a party lost this many seats in the midterm was the Democrats under President Roosevelt in 1942 when the Democrats lost 55 seats.


Over in the Senate, the race is much closer and the Democrats have a good a chance of retaining control. This is, of course, partially due to the fact that only 1/3 of the Senate is up for re-election every two years.  Polling at the state level currently suggests that the Democrats will have 48 seats, the Republicans will have 45 seats, and 7 seats are currently too close to call. The race that most recently shifted was the Kentucky Senate race between Republican Rand Paul and Democrat Jack Conway, which shifted from leaning Republican to too close to call.  With this shift the Intrade contract, which allows speculators to bet on whether the Democrats will retain the Senate, has been trading close to the 60% line.


The wild card over the next few weeks will be spending and turnout and with the recent inflows of capital into Republicans coffers, we should see continued gains in the coming weeks.


Daryl G. Jones

Managing Director


Today’s announcement of China’s central bank raising rates seems to have spooked the Macau gaming stocks. Historically, higher rates have been good for gaming revenues in Macau.



The Macau gaming stocks listed in the US and the S&P are taking a bruising today following the announcement that China increased benchmark rates by 25bps.  We think WYNN and LVS are expensive and October growth may disappoint recently elevated expectations.  However, recent history shows that higher rates have been good for Macau gaming revenues, not bad.


This morning we took a look at the last three years of Macau revenue data and regressed it on the China 1-yr Lending Rate.  We found that the correlations between interest rates and total gaming revenue, Mass gaming revenue, and Rolling Chip volume were all around 0.75.  That is a positive 0.75, not a negative correlation.  Moreover, interest rates were statistically significant in explaining the changes in gaming revenues with the highest t-stat present in the Mass to Interest rate equation.




Our macro view at Hedgeye is that higher interest rates and currency valuations are conducive to higher consumer spending.  This would explain the positive correlation with Macau gaming revenues and especially Mass gaming revenues.  We understand the liquidity argument that VIP revenues are driven in part by the availability of credit.  Higher interest rates do not necessarily mean less liquidity.  China appears to be awash in cash with capital still flowing in.  We do think the liquidity certainly needs to be monitored closely but for now we are not worried about a 25bp increase in rates.


MPEL looks to be most unduly penalized today since it is a pure play on Macau.  However, recent market share gains and market growth should lead to significantly better Q3 EBITDA and EPS than currently projected by analysts.  This should finally be the quarter that MPEL beats, and estimates move higher.

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