The Pounding In The British Pound, Is The U.S. Dollar Next?

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Includes: DBUK, DXPS, EWU, FKU, HEWU, QGBR
by: Peter Knight

Summary

Don't blame last night's sell off in the British pound on the world of algorithmic trading, we were already short, my first round buys to neutral didn't engage until 1.2310.

Don't blame it on the speech by French president François Hollande for a hard Brexit, really when was the last time you traded off any news generated out of France?

The sell off in sterling began in June as the direction of government policy and Brexit became clear.

It escalated in September after China was disappointed with talks that occurred at the September 2016 G20 summit in Hangzhou.

Its accelerated within a week of China’s currency becoming the 5th world reserve currency.

This move started long before last night.

Current chart

Post-Brexit Britain is now in a time of painful adjustment with China as a result of a new prime minister, a new government and new policies.

It's off to bad start in the wake of the September 2016 G20 summit in Hangzhou with increased trade tension between the two countries. In short China did not achieve what it had hoped to at the G20 summit in Hangzhou.

Regardless of the exact reason behind the overnight crash, there emerges an overarching point: it is not just about the UK's free access to the single market and trade becoming costlier; investors are now perplexed by the country's vision on immigration, openness and business-friendliness. This will be detrimental to the outlook for sterling given the global status that the UK has enjoyed for so many years. It is still too early to determine the end-result but one thing seems certain: sterling remains under severe pressure.

Of course, as many will point out, a decline in the currency is good for exporters. It is also good for the foreign currency earnings of the multinationals listed in the FTSE 100. But unless a currency is overvalued (as the pound was in 1992), it is folly for a nation to celebrate a sharp decline. If devaluation were the answer to economic success, people in Venezuela and Zimbabwe would be rich. A weaker currency is a decline in the terms of trade; the UK like the US runs a trade deficit which could escalate as it costs more for citizens to buy foreign imports.

I believe last night's sell off in Sterling was in majority generated by China as it flexes its currency manipulation muscle on a soft target prior to taking on the next round of UK trade negotiations and talks on deck with the US in 2017.

I don't think it's a coincidence we saw heavy Sterling selling out of Asia after China's disappointment at the September 2016 G20 summit.

Now less than a week after China's yuan officially became the 5th world reserve currency we see another very aggressive round of Sterling selling, again out of Asia?

The yuan in theory now has the same status as the U.S. dollar, the euro, the yen and British pound in the IMF's special drawing rights basket, which determines the currencies that countries can receive as part of IMF loans. It marks the first time a new currency has been added since the euro was launched in 1999.

G5 status reduces reserve requirements for China's, these freed reserves enhance China's ability to manipulate any currency up or down for what is in the best interest of their economy including but not limited to trade negotiations.

Is a US versus China currency conflict next?

Relations between the US and China have deteriorated to such a dismal level that China didn't even roll out the red carpet for Obama at the September 2016 G20 summit in Hangzhou.

The way it was 2014, the way it is now in 2016

A) 2014 appropriate exit and greeting in China for a US President
B) September 2016 G20 summit in Hangzhou exit (bottom of the plane).

Putin's greeting at the summit was a little warmer

Adding insult to injury China continued piling its criticism of the US, when Chinese President Xi Jinping said at the open of a two-day G-20 summit "that the global economy is being threatened by rising protectionism and risks from highly leveraged financial markets". He was referring to recent US trade war escalations, and Washington's recent response to Chinese dumping with duties on cold-rolled steel as high as 522%.

Like the Pound what the dollar also needs to fear

U.S. versus China's growth (Red)

Source Federal Reserve

U.S. Trade deficit, China's trade surplus (red)

Source Federal Reserve

U.S. versus China's debt to Gross Domestic Product

Source Federal Reserve

U.S. versus China's interest rates

The US has expanded its "balance sheet" for years with no sign of reversal. The only reason debt service cost has been contained is artificially low interest rates, tax receipt growth relative to the cost of economic stimulus is beyond pathetic.

US debt, debt service cost relative to tax receipts

Source Federal Reserve

The dollar is shaky near its 10 year high

Over 6 trillion of US debt and dollars is held by Foreign Investors, 1.218 trillion by China alone, I don't think I'm alone in seeing the risk on this.

Source Federal Reserve.

Breakdown of US debt owned by non US investors

Balance sheet expansion and China's potential currency manipulation now put EM central banks at risk to suffer the major damage.

EM reserves - so many of them held in the big four currencies - their credit ratings and purchasing power could be decimated. The world could easily become desperate for alternative currencies to act as replacements for the traditional reserve currencies when debasement efforts fully engage.

Current credit ratings


Source

So far, only one country, China, appears to have spotted the opportunities presented by this situation. Most others merely watch the US dollar in fear.

China is now officially a world reserve currency, it no longer needs as many reserves. The excess reserves can then be used for currency manipulation and sovereign wealth fund purposes, including but not limited to the AIIB (Asian Infrastructure Investment Bank).

China is now able to increase consumption, because it no longer needs to suppress domestic demand in order to maintain high levels of reserves.

China's yuan (Renminbi) Versus the USD

Source Federal Reserve

Even if I'm dead wrong in thinking China had a good part in what's happening with the British Pound I see the economic fundamentals being generated out of China (good and bad) fueling the kind of major market moves that technical traders like myself live for.

ETFs: EWU, FKU, DXPS, DBUK, QGBR, HEWU

Disclosure: I've been a professional trader and run a family office from Tortola, British Virgin Islands for the past 20+ years, zero income, corporate and inheritance tax and would like to keep it that way. Because of the potential tax implications I do not manage US accounts or sell advisory services to US clients.

I do however manage funds for a limited number of qualified non U.S. investors. I may at times for my own accounts or for the accounts I manage have positions on that could be contrary to the ones mentioned in my reports.

Disclosure: I am/we are short GBP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.