Last December I speculated the Peoples Bank of China (PBOC) would be forced to devalue the Chinese currency (Nov 25/15 – The CNY will be devalued and Dec 10/15 – One and done for PBOC too). I thought they would do a big one time devaluation right before the Federal Reserve’s first rate hike. That way, if things went FUBAR, the Chinese could blame it on the American rate hike. Instead of devaluing, the Chinese announced they would target a basket of currencies instead of just soft pegging to the US dollar.
I was wrong in my prediction, but the reasons I wanted them to do a one off revaluation lower instead of a series of smaller steps has now become painfully obvious to the Chinese authorities. By slowly walking the quote lower it encourages too much speculation. It becomes a one way bet. Instead of capital being attracted at the new lower price, it only encourages more capital flight and outright short speculation. If you have a managed currency that is pegged at too high a rate, you might as well just rip off the bandaid.
Instead as it has become obvious to even CNBC hosts the Yuan was headed lower, the flight of capital out of China has become a torrent. This has caused sell offs in the Chinese financial markets that has cascaded throughout the globe.
Faced with this onslaught, the Chinese authorities have been forced to curb the speculation through aggressive intervention. You knew it was coming, but last night we got the warning:
“Expectations the yuan will depreciate sharply should be seen as ridiculous and humorous,” warned one Chinese official.
These words were backed with action and the PBOC managed to bring the offshore CNH level back in line with CNY, along with stabilizing the price:
Yet here is the problem; the Chinese calmed the markets, but at what cost? When the PBOC intervened to buy CNY they withdrew liquidity from the economy. This caused a squeeze in funding. And last night’s move was epic!
The HIBOR (Hong Kong InterBank Offered Rate – the rate at which Hong Kong banks lends to one another) spiked to 66.815%!
The PBOC managed to stop the currency speculation (for now), but the cost was monstrous. Although I believe the Chinese Central Bank was correct to step in, the costs were much higher than they had to be.
My suspicion is the Chinese will learn from this lesson. In the coming weeks, they will stabilize the currency and get the speculators to move on to the next target. And then, just when everyone thinks the risk is gone – they will do a one off devaluation.
The Chinese currency still needs to go lower. Now maybe the Chinese will get lucky and the US dollar will sell off against most other currencies, skating the Yuan onside. But if it doesn’t, the Chinese need to find a better way to revalue the Yuan lower…
Crude oil update
I was already leaning towards the long side of the oil market (much to my chagrin), but yesterday one of my good buddies sent me an absolute terrific piece of analysis that has me foaming at the mouth to buy more.
It comes from Raymond James’ Canadian energy analyst Jeremy McCrae. The analysis is based on the shape of the crude oil curve. Currently the price of near dated crude trades for a lot less than the further dated deliveries.
The shape of this curve is known as ‘contango.’ What is unusual about this situation is that the slope of the curve is steep. Extremely steep. In fact, it is so steep that Jeremy McCrae labels it a “super contango.”
To measure the specific steepness Jeremy examines the price of the first month contract with the 12 month contract. He notes the current spread at 27% is one of the widest spreads since 1997. It ranks in the 1.6% of trading days. But most importantly, have a look at the stats that follow such a wide spread:
- Average Return 1 year Later: Historically, when the 12 month contract spread is 27% or higher (like today), the near-month contract 1-year later is up 89% (based on these similar spread levels seen only in 1998 and 2009), implying a WTI price of $59.40/bbl for Feb 2017.
- Probability Factors: In terms of probability, in all instances historically when the spread was 27% or greater, WTI prices were higher 1-year later. For context, when the spread is between between 0-10%, the probability declines to 66%; where when we see backwardation (spread is negative), the probability that prices are higher 1-year later declines to only 50%.
Near-Term Price Performance: We highlight the recent instances when contango spreads reached 20% or higher over the last 10 years and the subsequent WTI spot price performance very shortly after:
o Dec 11, 2015: Contango Spread reached 24% – WTI spot prices rose 7% 10 days later
o Aug 13, 2015: Contango Spread reached 20% – WTI spot prices rose 17% 13 days later
o Mar 16, 2015: Contango Spread reached 27% – WTI spot prices rose 18% 16 days later; and 39% 38 days later
o Jan 29, 2015: Contango Spread reached 23% – WTI spot prices rose 20% 15 days later;
o Apr 14, 2009: Contango Spread reached 30% – WTI spot prices rose 35% 23 days later; and 58% 38 days later
o *As a side note, spreads widened to 60%+ in Dec 2008 and remained above 20%+ until April 2009.
And here is Jeremy’s chart:
This is superb work. I wish I had done it. Recreating it with other commodities will go on my must do list immediately…
And if Jeremy’s work hasn’t convinced you about the merits of a long side trade, have a look at the price of oil in relation to gold:
We have just hit levels last seen in the depths of the 1986 crude oil bear market. Yesterday I sold some of my gold and replaced it with even more oil.
I know everyone is busy leap frogging themselves with more aggressive downside targets for crude oil, but I am standing in here, waving them in with palms facing inward… Bought from them…
Thanks for reading,