The Monetary Policy Relationship Between China And The US

  • May 26, 2004
  • Dave Floyd


The last few weeks have certainly been rather
indecisive as any FX trader will attest to.  What one moment seems
like a solid technical set-up, is a failed move the next moment.  Last week I
had mentioned that there were four factors weighing on the market at present.


  1. Strong
    US jobs and inflation data have eliminated any hope that the Fed will be on
    hold until 2005

  2. China’s
    tightening raises fears of a “hard landing”

  3. Rising
    oil prices


  4. Terrorism and geo-political risks

Perhaps it
is reason #2 that is the one that is most overblown.  Let’s look at the facts. 
Since the early 80’s China has experienced some rather large swings in GDP,
which inevitably led to some boom/bust periods.  (See chart below).  As you can
see, the present level of GDP growth/contraction is far more measured. 


The collapse in China’s economy
during the early1980s and 1990s was preceded by a rapid acceleration in GDP.
During this cycle, the recovery began
five years ago, and GDP has grown marginally from 7% to 9-10% over the past
several years. Therefore, China’s economy should decelerate at a slower pace
this time around.

Secondly,
with the Federal Reserve on the verge of raising interest rates, this will slow
the influx of “hot money” into China as US assets become more attractive.  This
scenario alone will allow Chinese policy makers plenty of breathing room and not
force them to have to raise rates as a way to take some steam out of the
economy.  History clearly demonstrates that monetary policy in China vs. the US
is always opposing.  If the US is raising, China is either flat or easing. 
Without the prospect of higher US rates, the China hard-landing would in fact be
more of a possibility.

With the
likely outcome of a soft landing in China, it makes sense to start looking at
the commodity-sensitive currencies.  As you know they have been sold off heavily
in recent weeks on the prospects of a China hard-landing.  As a result, we have
decided to establish long positions in the AUD/USD and short the USD/CAD.

EUR/USD

Comments
last week by Fed Governor Ben Bernanke dealt a blow to the recent rise in the US
Dollar.  Comments that were rather dovish on the pace of rate rises and some
comments alluding to the structural problems facing the US Dollar were not what
long Dollar players wanted to see.  With the EUR/USD having held solid support
in recent weeks, long EUR/USD positions are beginning to make a lot of sense not
only from a technical perspective, but also from a macro perspective. 


With the exception of the above mentioned trades, I would still
suggest laying low on “Swing Trades” as price action is still too erratic.  The
trades discussed this week are macro and to a lesser extend technically based. 
They will need time to play out and the stop losses should be set wider than
normal. 


I will keep you posted on any other developments.


Dave