China cuts interst rates

Australian employment rose unexpectedly by +39k in May, up from a revised +7k in April. Full time employment rose by 46k, the largest rise in a year, whilst temp employment declined by 7k. With much higher 1st Q GDP and much better employment data, Australia has certainly surprised to the upside. Don’t understand the strength, given the slowdown in China – maybe just on going projects which are being completed. The A$ rose again to 0.9982 against the US$. The data suggests that the RBA may pause in terms of interest rate cuts;

 

In another sign of concern, China is delaying implementation of tougher capital rules till the beginning of 2013. New bank loans declined by some 33% in April, from March. Will cuts in interest rates follow, in particular with slowing inflation as a result of the oil price decline – yep, I believe so. The new capital rules lower the capital adequacy of Chinese banks by as much as 2 percentage points and, in addition reduce the requirement to cover operational risks and has phased out the need for certain supplementary capital. Essentially, the new rules allow banks to count excess loan loss provisions as capital. In addition, risk weightings for small company loans and personal credits will be reduced. Furthermore, lenders will have a 10 year grace period to phase out securities which don’t qualify as capital and, in addition, banks will be given a further 3 years to meet the latest capital requirements. These measures confirm the (stealth) easing policy;

 

China has reduced interest rates by 25bps, the 1st time since since 2008, with the benchmark 1 year lending and deposit rate at 6.31% and 3.25% respectively. The authorities have also increased flexibility for banks to price within a large range around these rates. Whilst the timing of the move was a surprise, the actual cut should not have been, as I have banged on for some time now. The Chinese economy has been weakening far faster than suggested by most analysts and with a major change in personnel (with the need for social stability – the key priority of the Chinese Communist party) later this year, further easing was inevitable, especially as inflation is declining, given lower oil prices, in particular. The move will lift the mining sector, my way of playing China;

 

Chinese investment into Europe tripled to US$10bn in 2011. The FT reports that investment could surge to between US$250bn to US$500bn by 2020 (roughly a quarter of all FDI by China). I certainly believe that the Chinese buying of (cheap) European assets is a much better investment for them than buying overpriced sovereign debt in Europe and the US. Chinese authorities are encouraging businesses to invest overseas;

 

Bloomberg reports that China is to approve US$23bn of steel projects, which should help the relevant commodity producers. As China has significant excess capacity, this makes no sense whatsoever, though the Chinese are the Chinese. Steel production could well rise to 700mn tons this year, up from the 683mn last. Iron ore and coal suppliers should benefit, as will Australia;

 

PM Manmohan Singh promised to spur growth in India, through capex projects including new ports, roads and power plants worth some US$6.3bn in the fiscal year to 31st March 2013. Infrastructure is vital for India, but is inevitably mired by large scale corruption, bureaucratic delays, lack of organisation, etc, etc. This new measure is unlikely to be any different. In addition, India needs to liberalise its economy – however, today India deferred a decision on whether to allow FDI in the pension fund industry – basically, the same old, same old. The Rupee rallied on the news, but I remain sceptical;

 

Greek March unemployment rose to 21.9% from 21.4% in February. Cant see any improvement in the near future;

 

The Swiss have been intervening heavily in the forex markets to stop their currency revaluing above the 1.20 peg (against the Euro) – the 1st time since last September. Forex holdings soared to CHF303.8bn at the end of May, from CHF237.6bn at the end of April. I don’t understand why dealers are continuing to bet against the SNB. They announced a clear policy and will defend it – much better trading opportunities around, other than the Swissy, I would have thought;

 

The FT reports that the EZ is considering providing funding directly to Spanish banks with little oversight (quite possibly through the Spanish bank rescue “fund”, the FROB), other than that already agreed with the EU. Funds in excess of the E40bn (the Spanish estimate) are being talked about – more like double that amount. There is concern as to the management of Spanish banks, post any recap. The Spanish authorities will want to wait till their consultants review the financial position of the banks. The news is surprising given the strong statements by Merkel supporters to the contrary, warning that the EZ would not provide funding, without additional supervision. If Mrs Merkel does indeed cave in, it will set a bad precedent. Interestingly, Draghi (at yesterday’s ECB press conference) stated that he did not believe that Spain would require addition overview/supervision (a la Ireland, Portugal and Greece), saying that there were adequate provisions in place at present;

 

The Spanish bond auction (target E1bn to E2bn) was successful – approx E2.07bn of bonds were sold. Whilst the overall size of the bond auction was small, the bonds sold were of medium to long term durations. Bid to cover was better, at 3.3 times. 10 year Spanish bond yields have decline by 14bps at present to 6.05% – they were over 6.60% recently – the auction priced the 10 year at 6.04%;

 

French unemployment rate rose to 10.0% in the 1st Q, up from 9.8% in the previous Q. The rate looks as if it will rise further;

 

Bloomberg reports that opposition to a plan for a debt redemption fund (by Merkel) is weakening, according to 2 of her allies, though she is still not on board. “I see some movement in the government” towards a proposed debt redemption fund, reported Mr Lars Feld, an economics professor at Friedburg University and a member of Mrs Merkel’s council of economic advisers. The head of the CDU’s business group suggested that he would support debt pooling over say 50 years. The debt redemption plan was prepared by the 5 members of her economic council and is backed by opposition parties. The panel studying this idea is focusing on 3 areas to broaden acceptance of the plan, including addressing (a) “opposition to its sheer size”, (b) concern that it may not comply with German constitution and (c) international treaties and the scope of its proposal on member states liability. The fund could be some E2.3bn in size. Certain aspects remain murky to say the least, though. The really interesting position is going to be that taken by Hollande/France, who will be very anti measures to strengthen oversight, which will be a prerequisite;

UK May services PMI came in at 53.3, higher than the 52.4 expected and unchanged from April. New business component rose to 54.8, the highest since January, though business confidence weakened. Inflation seems to be weakening with employment rising at a “solid rate”. Sales prices came in lower, supporting sales volumes.. The pick up is important as the UK’s service sector is the main driver (75%+) of the UK’s economy. The composite PMI declined to 52.3 in May;

 

As expected, the BoE kept interest rates on hold (0.5%) and, in addition, did not add to the QE programme. Increasingly, economists believe that the recent poor UK economic data should be treated with a great deal of suspicion. Sterling, which has been a dreadful performer recently, though should continue to pick up;

 

The FED beige book (reviewing data from April to 25th May and based on reports by its 12 district bank) stated that the US economy expanded at a “modest to moderate” pace, slightly worse than the “moderate” pace previously. Employment was steady to slightly higher. Manufacturing was up, with wage and inflation pressures contained. Real estate had improved and car sales “remained strong”. Overall, the report stated that “economic outlooks remain positive, but contacts were slightly more guarded in their optimism”. All in all, I would say somewhat better than expectations. Should be supportive of the US$;

 

US initial jobless claims fell by 12k to 377k, in line with forecasts. The prior week was revised somewhat higher to 389k, from 383k. The less volatile 4 week moving average is up marginally to 378k, from 376k. Continuing claims rose by 34k to 3.29mn;

 

Brazilian annual inflation fell to 4.99 in May, the 1st time its below 5.0% since 2010 – Brazil’s target is for inflation to be around 4.5% +/- 2 percentage points. The Central Bank has cut interest rates from 12.5% to a record low of 8.5%. Whilst inflation is expected to decline further (for how long though?), growth remains a problem. I remain bearish on Brazil;

 

Outlook

 

Asian markets closed higher following yesterdays strong US markets. European markets are trading higher – Germany is up over +1.7%, as is London. US futures suggest that markets will rise by some +0.75%.

 

Brent picked up following the Chinese interest rate cut and is hovering just below US$102, with gold around US$1620.

 

German 10 year yields continue to rise – currently 1.38% (over 20 bps higher than very recent lows), though French (the 10 year was auctioned at 2.46% today) and other EZ yields are contracting. I must say, I’m surprised at the decline in French yields, in particular – though Hollande has reconfirmed his commitment to reducing France’s budget deficit to 3.0% next year – hmmmm. Demand for French Sovereign debt at todays auction was strong today.

 

The announcement of a cut in Chinese interest rates has certainly resulted in much improved markets. Whilst yesterdays rally was mainly due to short covering (unlikely to have ended), there are signs of bullish government policy actions globally. A number of shorts have not covered, I suspect, which suggests that this rally has further to go. However, it really has become a traders market.

 

In Europe, the German market should react positively to the Chinese news. In Asia, Korean, Japanese and further south the Australian market. Continue to believe that the energy sector remains oversold.

 

We await Uncle Ben testimony later today. Cant see him being negative for markets, though he is unlikely to signal another QE programme either.

 

Kiron Sarkar

 

7th June 2012

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