The pain in commodity land continues overnight. The catalyst for the latest sell off is the terrible Chinese manufacturing PMI number. Analysts were expecting slightly over 50, but the actual number came in at a little over 48.

A reading below 50 means the Chinese manufacturing sector is contracting.

Why any analyst believed the Chinese economy is holding up is beyond me. The decline in the commodity sector makes the true extent of the Chinese economic perfectly clear. All you need to do is dial a chart of copper, iron ore or gold to realize the Chinese economy is in terrible shape.

And it is no wonder. The strength of the Chinese Yuan makes it like treading water holding a cement cinder block.

The Japanese Yen has been devalued against the Chinese Yuan by over 65% over the past couple of years. Although it is probably one of the weakest crosses, the fact China has tied its currency to the US dollar means almost all currencies are down dramatically against the Yuan.

The trade weighted Yuan chart resembles what technical analysts call the rocket ship formation:

Ever since the end of the credit super cycle in 2008, every country that has allowed their currency to appreciate has imported the world’s deflation and eventually been forced to ease aggressively to counteract the self reinforcing debt destruction vicious circle.

In 2010 and 2011, the Japanese did not match the Americans’ aggressive monetary expansion. This relative monetary tightness meant the Yen rallied, and the Japanese economy suffered as they imported the world’s deflation.

Eventually this proved too much even for the stoic Japanese people. They elected a new leader whose platform was based on an aggressive monetary expansion. Ever since then the Japanese economy has shed its deflationary tendencies.

When the Japanese started up the printing press, the Americans were still engaged in quantitative easing. The Europeans on the other hand were scolding the world about the dangers of aggressive monetary policies. During this period the ECB was actually allowing their balance sheet to decline! Again, by refusing to ease aggressively Europe imported the world’s deflation. The Euro rallied and the economy tanked.

The ECB (led by our hard money German friends) held out for a while, but when the EURJPY spiked to 150 the pain ultimately proved too much to be bear and the ECB tapped out. By waiting so long, the ECB had to take the unorthodox step of pushing rates into negative territory.

In both the Japanese and the European situation, the mistake was waiting too long. Each time the countries’ leaders believed they could withstand the urge to inflate aggressively. And each time, the deflationary wave was simply too large.

This is happening today in China. The leaders are hoping they will be able to withstand the deflationary forces engulfing the Chinese economy. Yet, the longer they refuse to inflate, the more the vicious deflationary circle becomes entrenched.

The hard money skeptics will say this purging is needed. They will argue this is a natural process that clears the way for the next up leg. I can’t say I disagree. But unfortunately the world has become so over indebted, the deflationary forces are overwhelming.

So far any country that has attempted to allow the credit destruction process to take its course has panicked when the full extent of the facade has become evident to market participants.

I don’t see the point of even pretending this system is working properly. In my mind, the sooner we get on with the inflationary reset, the better off we will be. Every time we try to withdraw the liquidity, the economy falls flat on its face. There is no sense trying to pretend these debts will be paid back with today’s dollars. Inflating our way out of this mess is the only real politically palatable solution.

Today we have China trying to pretend their debts don’t need massive monetary support to stay aloft. Their economic pain is intensifying, and I don’t think they make it through the summer without a major monetary (and maybe fiscal) policy shift. Who knows, there is a decent chance they don’t even make it through the week-end.

Japan, Europe and now China have all tried to be (relatively) monetarily responsible. They have all learned the hard way about the problems with a balance sheet recession. How long before that stark reality hits the US economy?

An attempt at a trading call

This week has been a relentless, brutal collapse in the price of commodities. This morning gold is breaking to new lows, and no commodity looks anywhere close to bottoming.

Over the years I have found that this sort of Friday morning action of an extended move often accelerates during the morning session. Traders that have been trying to catch the bottom finally capitulate as they don’t want to hold it through the week-end. I know this all too well because too often it has been me that is puking.

I think the upside risk in gold and most other commodities greatly outweighs the downside. I have started buying out of the money gold calls in anticipation of a face ripping rally. But this morning I am in no rush. I might miss the bottom, but who cares? For the next four hours I expect some “this will never work” selling. These traders are more frustrated than a 17 year old boy who couldn’t get a date for prom. I expect these guys to pitch their positions. At lunch, when they are all flat and vowing to never trade commodities again from the long side, I will pick up their positions.

China often makes big policy changes over the week-end. I would be surprised if we made it to Sunday night without China doing something. Whether it will be enough is open to debate, but I contend the risks of gold spiking $100 higher is greater than it declining by the same amount.

Thanks for reading and have a great wk-end,

Kevin Muir

the MacroTourist