Key Currencies In The Cross Hairs

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Includes: CNY, CYB, DBMX, EWW, FXCH, GDX, GDXJ, HEWW, MXE, MXF, MXNS, QMEX, SMK, UMX
by: Ivan Martchev

In the past couple of weeks, the two currencies that are in the cross hairs of President Trump's trade agenda - the Mexican peso and the Chinese yuan - have had rather divergent reactions. The Mexican peso strengthened, while the Chinese yuan weakened. Why the divergence?

Chinese Yuan versus Mexican Peso Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This chart reflects an inverted exchange rate quote, so that more pesos or yuans per U.S. dollar mean weaker currencies and vice versa, so when the chart line is going up, the currency is weakening (and vice versa).

From a long-term view, I expect the Chinese yuan to weaken significantly while the Mexican peso can strengthen quite a bit if a pragmatic new NAFTA deal is negotiated. U.S. Commerce secretary Wilbur Ross directly referred to the peso last week along those very lines on live TV: "I believe that if we and the Mexicans make a very sensible trade agreement, the Mexican peso will recover quite a lot."

Voila, the peso immediately spiked higher. Was this the necessary clue that the U.S. realizes that the Chinese and Mexican situations are fundamentally different? That could very well be the case.

United States Imports from and Exports to Mexico Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In 2016, Mexico bought $230.96 billion of U.S. exports and the U.S. bought $294.15 billion of Mexican goods and services. While that makes for a $63.19 billion trade deficit, the situation is fairly stable, since bilateral trade keeps surging in both directions, primarily due to NAFTA. Furthermore, 40 cents of every dollar of the U.S.-Mexican trade deficit comes back to the U.S. in the form of manufactured goods, the majority of whose components were imported from the U.S. (Source: www.trade.gov: U.S. Department of Commerce, Census Bureau. "Top U.S. Trade Partners" ranked by total 2016 export values. For more information, see my MarketWatch January 31, 2017 article, "Donald Trump picks the wrong target with his Mexican standoff.")

On the other hand, the trade deficit with China is grossly unbalanced. There is no reciprocal rise in Chinese imports from the U.S. (blue line, below), as there is with Mexico (above).

United States Imports from and Exports to China Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In 2016, the Chinese bought only $115.78 billion of U.S. goods and services while the U.S. bought $462.82 billion worth of Chinese goods and services. That's a whopping $347.04 billion trade deficit. (Source: www.trade.gov: U.S. Department of Commerce, Census Bureau. "Top U.S. Trade Partners" ranked by total 2016 export values.)

I believe that the Chinese could be buying a lot more U.S. goods and services, but instead they are sending their money to trading partners in Asia so that they can increase their political influence in the region. While this longstanding trade strategy would be something that the legendary Chinese general Sun Tzu would be proud of, it is not something that will be tolerated by the new Trump administration.

The Chinese yuan came under pressure way before President Trump came into office, for various reasons. I believe the Chinese have a busted credit bubble that will force the Chinese central bank to engineer an overnight devaluation similar to what they did in December 1993, when they devalued by 34%. The timing of such a devaluation is unknowable, but I believe it is a high probability event. (For more, see my February 20, 2017 MarketWatch article, "China's economy is dangerously close to unraveling.")

The election of Donald Trump couldn't have come at a worse time for the Chinese as their domestic economic situation was already having serious issues. Even though the Trump election and the situation in the Chinese financial system are unrelated events, they can feed on each other rather dramatically.

Chinese Yuan versus China Foreign Exchange Reserves Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Chinese foreign exchange reserves have now dropped by $1 trillion since their peak in mid-2014. Before they drop another trillion, we are likely to have some sort of People's Bank of China (PBOC) action on the exchange-rate front as an overnight devaluation bypasses the improperly functioning Chinese financial system. I think such a devaluation is coming and the best way to estimate when it might come is by monitoring their accelerating forex outflows, which are reported monthly by the PBOC.

Data compiled by Kynikos Associates shows that if you net foreign borrowings by mainland entities, the actual forex reserve is much closer to $1.7 trillion than the officially reported number, close to $3 trillion. This much lower net reserve calculation also suggests that a more dramatic hard overnight devaluation is likely to happen before Chinese official forex reserves drop by another trillion.

One has to wonder if going long the Mexican peso against the U.S. dollar and going short the Chinese yuan is not a trade to be made in 2017. I know the Chinese yuan is not easy to trade and a lot of trading is done through non-deliverable forwards in Hong Kong, available only to institutional investors. Further complicating matters are PBOC bear raids in the HIBOR market, where they try to push overnight lending rates in order to squeeze Chinese yuan shorts. There was such a spike to 110% in early 2017 and another one that was 66% in early 2016 with a few smaller spikes in between.

Shorting the Chinese yuan is deliberately made more complicated to discourage speculation, but I don't believe that speculators are driving the forex outflows. Instead, it's the busted Chinese credit bubble. It is only a matter of time before the situation in the Chinese financial system is again front-page news.

Eerie Calm in the Commodity Markets

Things have not been calm in major commodity markets since the big decline began in 2014, but prices have been basically moving sideways for months. If one looks at a popular gauge like the Goldman Sachs Commodity index, one can see what in trading terminology can be referred to as a "volatility squeeze."

Goldman Sachs Commodity Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

One rule of thumb that traders use is that volatility squeezes tend to break in the direction of the major trend, which is down, in my opinion. There is always the issue of whether a trader is speaking from a short- or long-term perspective, but since focusing on too short-term a move feels to me like a dog chasing one's tail, I prefer to look at trends with an intermediate- to long-term perspective.

Gold Price Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This volatility squeeze in major commodity indexes brings me to gold, which had a significant rebound since reaching an intermediate-term low in December 2016. I am on record as thinking that we may see the gold price decline below $1,000 in 2017 and the latest intermediate-term rebound has not changed that view. (See my December 29, 2016 MarketWatch article, "2017 is the year gold drops below $1,000.") It would have been a perfect dead-cat bounce if the gold price rebound had fizzled near $1,200/oz., but the fact that it overshot does not really mean that the Midas metal is out of the woods.

Market Vectors Gold Miners Exchange Traded Fund (NYSEARCA:<a href='https://seekingalpha.com/symbol/GDX' title='VanEck Vectors Gold Miners ETF'>GDX</a>) Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I am mentioning this as we had a rather significant sell-off last week in gold mining stocks as measured by the Market Vectors Gold Miners ETF (GDX), shown here, as well the Market Vectors Junior Gold Miners ETF (GDXJ, not shown). Moves in gold mining stocks have been known to lead the gold price both to the upside and to the downside. This is because of the operational leverage of unhedged gold mining companies where smaller moves in the gold price get magnified in their profit and loss statements. (Please note: Ivan Martchev does not currently hold positions in GDX or GDXJ. Navellier & Associates, Inc. does not currently hold positions in GDX or GDXJ for any client portfolios. Please see important disclosures at the end of this letter.)

This makes the December 2016 lows in both gold ETFs and the gold price for that matter, important milestones. If breached soon, let's say before mid-year, that would be a strong indication that the gold price is on its way to meet its destiny at $1,000 or below.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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