China hikes rates - implications?

Risk appetite didn’t take kindly to the Chinese rate hike the day before China is open for business after its extended New Year holiday. What are the implications of this and future tightening moves in China for the major currencies?

China hikes rates
Ahead of the reopening of markets after the Chinese New Year festivities, the Chinese regime decided to kick things off with a modest rate hike aimed at slowing the overheating Chinese economy – or at least, its overheating inflation levels. The 25-bp. Increase brings the one-year benchmark lending rate to 6.06% and takes the deposit rate to 3% from 2.75%. The reaction in markets was understandable, as fears of a slowing China hit commodities and risk appetite more or less across the board. In FX, the action was relatively muted, but the rally in AUD was pushed back after AUDUSD had a try at the high end of the recent range.

It is clear going forward that the Chinese regime will continue to move against inflation and the question is more one of whether the landing for the Chinese economy will be a soft or hard one. It is a critical year for China due to the magnitude of its challenges – exacerbated by its panicky response to the air pocket the Chinese export engine hit when the global financial crisis hit, and politically, as the regime deals with a leadership transition and new five year plan. We should always bear in mind that a command economy can build even larger imbalances and grotesque economic distortions than any market economy because of the regime’s authority to dictate policy and manipulate short term incentives for an economy’s participants.

With the world’s most important engine of growth engaged in this critical fight to get control over domestic asset bubbles and rampant inflation, it is clear that this presents a huge risk to the otherwise very rosy market outlook other markets seem to be expressing.  Meanwhile, grain prices remain close to recent highs and it’s a given that the weather and crop yields aren’t affected by the interest rate mechanism.

Odds and Ends
NZDUSD pushed higher overnight, despite the Chinese rate hike and despite the fact that the 2-year New Zealand-US interest rate spread recently traded at the lowest level since September of 2009. We’re note sure if this is the market playing the currency as a “food currency” considering its very significant agricultural outputs or something else, but rarely have fundamentals and market reality diverged so dramatically as we are seeing at present.

The UK RICS House Price Balance was better than expected for the second month in a row, though the housing market in the UK continues to experience a slow-down.

Weekly US ABC Consumer Confidence nearly rose to the highest level since before the global financial crisis begain. The history of consumer confidence surveys (both the ABC and Conference Board surveys) relative to unemployment is an interesting and highly correlated one – and usually confidence actually leads the actual changes in the employment level – and certainly confirms it. So we need for confidence to show strong signs of improving (first signs are there, but we need a couple of break through readings to boost any belief that the situation is improving a much as the underlying and often misleading employment rate suggests.

The Fed’s Lacker (non-voting alternate member of FOMC) is out speaking as we are writing this and said that the Fed should “seriously” re-evaluate QE as he predicted inflation of 1.5-2.0% and continued improvement in the jobs market. This rhetorical tangent will likely be taken up by the Dallas Fed’s Fisher later in the day, as he is the most vocal hawk among the voting members.
Looking ahead
Today we have the first of a trio of US treasury auctions this week, as $32 billion of 3-year notes go on the block. Many will say that the demand at these auctions isn’t necessarily show what US treasuries are worth in the free market due to the Fed’s QE2 program, but foreign and other demand is measurable at these auctions and they will have a bearing on interest rates, which are critical at this juncture after the strong move higher last week. 

The biggest reaction to the auctions will likely be felt in the JPY crosses. On that account, it is worth noting that the 2-year interest rate spread has ballooned recently in favor of the USD over the JPY, but the market has not responded with more than the most tentative rallies in USDJPY above recent short term resistance. If rates continue higher, the pressure on USDJPY may increase to the upside. It’s either that, or we are seeing a new divergence in currency market behavior relative to interest rates – and we’re not ready to suggest that is the case.

Chart: USDJPY vs. US-Japanese interest rate spread
With the recent rise in interest rates, the spread between US and Japanese interest rates at the front end of the curve (we always use the 2-year to capture forward central bank expectations) has stretched back toward its widest level since the middle of last year, when USDJPY was trading closer to 90. We will watch the reaction to the US treasury auctions this week with great interest for the reaction in the JPY crosses.

Also interesting for today will be the reaction in the US equity market and the USD to the rate hike out of China and whether anything can throw a wet blanket on risk appetite in the US.

Economic Data Highlights

• US Dec. Consumer Credit rose $6.1B vs. $2.4B expected and $2.0B in Nov.
• New Zealand Jan. QV House Prices fell -1.5% YoY vs. -0.9% YoY in Dec.
• Japan Dec. Adjusted Current Account Total out at ¥1556B vs. ¥1531B expected and ¥1145B in Nov.
• Japan Dec. Trade Balance out at ¥768.8B vs. ¥780B expected and ¥260B in Nov.
• UK Jan. BRC Retail Sales Monitor showed same store sales out at +2.3% YoY vs. -0.3% YoY in Dec.
• Australia Jan. NAB Business Confidence out at 4 vs. -3 in Dec.
• Australia Jan. NAB Business Conditions out at -6 vs. 6 in Dec.
• Switzerland Jan. Unemployment Rate out unchanged at 3.5% as expected
• Germany Dec. Industrial Production out at -1.5% MoM and +10% YoY vs. +0.2% +11.5% expected, respectively and vs. +!.1% YoY in Nov.
• US Jan. NFIB Small Business optimism out at 94.1 vs. 94.0 expected and 92.6 in Dec.
• Canada Jan. Housing Starts out at 170.4k vs. 173.5k expected and 169k in Dec.

Upcoming Economic Calendar Highlights (all times GMT)

• US IBD/TIPP Economic Optimism survey (1500)
• US Fed’s Lockhart to Speak (!800)
• US Fed’s Fisher to Speak (1830)
• US Weekly API Crude Oil and Product Inventories (2130)
• New Zealand Jan. Credit Card Spending (2145)
• US Weekly ABC Consumer Confidence (2200)
• Australia Feb. Westpac Consumer Confidence (2330)
• UK Jan. BRC Shop Price Index (0001)
• China Jan. HSBC Services PMI (0230)
• Japan Jan. Consumer Confidence (0500)
• Japan Jan. Machine Tool Orders (0600)