Inflation Rope-A-Dope Incoming

Barring a surprise, it looks like the next round of inflation rope-a-dope is underway. Policy and indicators out of China have that 2018 ring to them. See: Chinese Economy Slowing, RE Investment Down, RRR Cut Incoming.

Here is China's FX reserves. Note the surges in FX reserves in the early 2010s that line up with the Federal Reserve's quantitative easing policies. There was no surge this time, only the yuan rallied. The yuan looks to have made at least a short- to intermediate-term peak, FX reserves are still inversely correlated with the U.S. Dollar Index. To top it all off, China still has only tightened capital controls with the latest move being a ban on Bitcoin mining.

At the end of June, China's FX reserves fell below 9 percent of M2 money supply. Depreciation since then has lifted it back to 9 percent, but that will be offset by credit growth. Viewed another way, there are now 72 yuan in M2 floating in the economy for every 1 dollar of reserves.

Everytime I post these charts I say the same thing: it doesn't matter until it does. If China had a floating yuan, low reserves aren't a big deal because like the U.S. or Europe, China could create more reserves as needed in its own currencies. The question for China is: what would happen if they opened the capital account? If the yuan would surge higher without capital controls, then low reserves aren't a big issue. If the yuan would collapse, that the capital control tightening via a ban on Bitcoin mining tells us pressure is building. The above two charts won't matter until the moment the market starts selling the yuan, and then everyone will be focused on whether China has enough assets to back the yuan. Overlaying all of this is the U.S. dollar. If the dollar declines, China will see FX pressure alleviate. If the dollar rises, China will be squeezed again and if they've dedollarized more than we know, they'll be in extra trouble because reserves will decline faster.

M2 growth remains slow, but it hasn't yet dropped into a lower gear. The 3-month annualized growth rate in June was 7.5 percent, up from 7.1 percent in 2018 and 6.9 percent in 2019, but down from the 10.7 percent in 2020.

In contrast, total social financing (TSF) has rapidly decelerated from a peak of 13.7 percent annualized growth in October and still 13.3 percent annualized growth in February, down to 10.9 percent in June. That's on par with pre-pandemic growth rates in 2018 and 2019. TSF increased 34.18 trillion yuan over the prior 12 months in February, but as of June, the 12-month increase is down to 29.76 trillion. Prior to the pandemic, the 12-month increase was around 22 to 23 trillion in most months. Credit growth is still high in absolute terms, but the deceleration is what matters for credit events.

As a major importer of commodities and the engine of physical economic growth, any slowdown or hiccup in China will have a huge impact on commodity prices. China is the marginal buyer of copper and oil. It filled its strategic oil reserve last year, removing this buffer from the oil market.

Aside from evidence that China is slowing, global markets have bid up asset prices, shorted U.S. treasuries and the U.S. dollar. Investors are convinced U.S. stimulus will pass, whereas the odds are moving in the other direction with moderate Dems and the GOP getting skittish. Former President Trump waded in as well, telling Senators not to trade tax hikes for "infrastructure." I have to assume a bill will pass, but it wouldn't take much to shift the GOP away from a deal, followed by moderate Dems. The clock is running out on this legislative calendar. Polling shows the GOP can win in 2022 by doing nothing, with moderate Dems vulnerable. Additionally, while I expect disinflationary forces will work in favor of a stimulus bill, if you expect higher inflation, the odds of a stimulus bill will collapse as inflation quickly becomes a top issue for midterm voters.

Investors have bid up all manner of assets. "The Fed won't let the market drop" and "They can't let it go down" are common attitudes among investors. Call buying is off the charts. Sentiment is much more bullish than it was on the eve of Volmageddon. From the perspective of a specultor, it won't take much for the currently bullish, inflationary picture to turn into another hellscape for stock investors and central bankers. Unfortunately, gold may sink at first in these conditions, but it will again be among the first to exit.