Viewpoints: U.S. Dollar at dusk
Dollar peaking, China equities about to enter the bull market - Viewpoints from Bei Li, the founder of Banxia Investment
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In the current situation where US interest rates continue to reach new highs and there are pessimistic sentiments surrounding China's equities and the Yuan, it is important to understand the outlook of Renminbi assets. With the improving macroeconomic conditions of China's economy, some market participants have expressed the view that China's equity market may present an opportunity. In today's post, we provide a translation of a two-part article titled "美元黄昏 U.S. Dollar at Dusk" (part 1 & part 2), written by Li Bei, the founder of Banxia Investment and one of the most influential investors in China's market.
About the author and Banxia Investment: Banxia Investment is an investment firm that specializes in macro strategies and manages assets worth billions of CNY. Li Bei, a private equity expert specializing in macro investments, provides insights into the current global macro situation and investment opportunities. This WeChat article has surpassed 100,000 views in a very short period of time. Such page views is very rare for financial content. This demonstrates the influence of this article. She clearly expresses her viewpoint that the U.S. dollar could soon reach its peak, and both the Chinese Yuan and the Chinese stock market may enter a bull market.
Below is Baiguan's redacted translation of the author's main viewpoints to help you understand Bei Li's key perspectives on why she holds such beliefs.
美元黄昏 U.S. Dollar at dusk
By Bei Li on Oct. 6, 2023
The U.S. dollar may enter several years of sustained depreciation, while the Chinese Yuan and the Chinese equities may enter a bull market.
During China's National Day holiday, there were a lot of events overseas.
First, US bond interest rates have continued to rise, with the benchmark 10-year Treasury yield surpassing 4.8% at one point. Then, a major event occurred, with the Speaker of the US House of Representatives, Kevin McCarthy, being voted out. The Federal Reserve (Fed) incurred a loss of over $50 billion in the first half of the year, and it is expected to have a loss of over $100 billion for the whole year, marking the first loss in nearly a hundred years. As a result, the Fed has announced plans to significantly reduce its workforce by 300 people.
These three things may not seem related at first glance, but they are all outcomes of the same factors—ultra-strong fiscal stimulus in the United States following the pandemic, combined with excessively loose monetary policy, low-interest rates, and experimental quantitative easing measures implemented since 2008.
After the 2008 financial crisis, the United States implemented an unprecedentedly strong monetary and fiscal stimulus. These policies are seen by some as lacking principles and boundaries. However, evaluating them purely from a technical perspective, they are pioneering and experimental, without historical precedents or references for their consequences.
These experimental policies have borne many “fruits on the vine”. In the early stage, most of them were “sweet melons”. Economic growth, high increases in income, full employment, expansion of corporate profits, a rising stock market, and a strong U.S. dollar. However, as time goes by, more and more “bitter fruits” have been produced. These include high inflation, declining purchasing power, widening trade deficits, numerous small banks collapsing, significant losses for the Federal Reserve, a divided political arena, and a lack of sustainable economic growth momentum.
Perhaps, it confirms the simple truth that there is no free lunch in the world, and all seemingly gifts from heaven come at a cost.
In my opinion, the current strength of US bond interest rates and the US dollar is the last gasp, like the vibrant sunset before it fades away.
Due to the excessive overuse of strong fiscal stimulus in the United States, it is difficult to sustain. Even if the budget deficit remains at the current planned level of 6.8% next year, the interest expense will significantly increase and occupy a large portion of the deficit space. The United States will also shift towards substantial fiscal contraction next year, and the economy is likely to experience a recession beyond market expectations. US bond yields will also significantly decline, and the US dollar will enter a period of depreciation that may last for several years. [Baiguan: paragraphs redacted]
Baiguan: The author then explains her viewpoints on the prospects of the dollar and key factors why she believes the dollar might be peaking.
1. Behind the strong dollar
At the beginning of the year, the market's consensus expectation was that the United States would experience a recession, with interest rates declining. However, the reality is that the resilience of the US economy has far exceeded market expectations, and US bond yields have reached new highs.
But more than half a year has passed, and the situation is now very different: the growth rate of industrial and commercial loans has slipped to zero, and the growth rate of household loans has significantly declined to around 5%. Many other indicators in the United States have also shown a downturn. Existing home sales in the United States, which account for over 80% of real estate sales, have hit a new low and are near the lowest level in 20 years. The confidence and expectations of U.S. residents have turned downward in the past two months. [Baiguan: paragraphs redacted; author's discussion on the SVB bankruptcy was omitted for conciseness]
In the past two quarters, the biggest upward force that has sustained the resilience of the US economy is US fiscal policy.
The 12-month rolling fiscal deficit/GDP ratio, which was less than 5% in the third quarter of last year, rose to over 8% in July this year.
What does an 8% fiscal deficit as a percentage of GDP mean?
The internationally recognized red line for fiscal deficits is 3%. Taking a longer-term view, in the early 1980s, during the Reagan administration's Star Wars program and large-scale fiscal expansion, the deficit only increased to 5%. During the once-in-a-century financial crisis of 2008, it reached 10%.
During this pandemic, the US government implemented an extremely strong fiscal stimulus, resulting in a deficit rate surpassing that of the 2008 financial crisis, reaching a historical high of 15%. While it made sense to take such aggressive measures in the face of the unknown virus and with low-interest rates, now that the pandemic has passed, inflation remains high, the economy needs to cool down, interest rates have significantly risen, and the cost of the deficit has surged. The side effects have also increased while the benefits have decreased substantially. However, the Biden administration has become reliant on fiscal stimulus and is unwilling to reduce the strength of the stimulus. [Baiguan: paragraph redacted; the author's discussion on the controversies within the US government is omitted for conciseness.]
More importantly, the nominal fiscal deficit cannot measure the real driving force of fiscal policy on the real economy and needs to deduct interest payments on existing national debt.
In the 1980s, the US government was able to withstand interest rates of over 10% while pursuing the Star Wars program and fiscal expansion because the government's leverage ratio was at historically low levels, at less than 40%. However, after the pandemic, the US government's leverage reached a historical high of 120%, three times the previous level. This means that the interest rates only need to be one-third of the previous level to have the same debt burden.
Even if the US fiscal deficit remains at 6.8% of GDP next year, which is the fiscal deficit budget for 2024, a significant portion will be used to repay interest. This means that from the perspective of supporting the real economy, the US economy will face significant fiscal contraction next year. [Baiguan: Paragraph redacted; the author's estimation of the US's debt burden outlook is omitted for conciseness.]
2. Why are US bond interest rates still reaching new highs?
Because of a reversal in supply and demand.
Supply-side: In the first half of the year, the US deficit level itself was not high, mainly relying on the consumption of the Treasury account balance, and the issuance of bonds was not large, remaining at a relatively low level compared to the past few years. In the second half of the year, the issuance of bonds increased significantly compared to the first half, reaching the highest level for a single quarter except for the second quarter of 2020.
Demand side: Due to the small bank storm, such as Silicon Valley Bank, the Federal Reserve temporarily stopped tapering in the first half of the year and expanded its balance sheet again. Throughout the first half of the year, the Federal Reserve's assets and liabilities remained basically stable. However, as the storm in the banking industry subsided, the Federal Reserve began to quickly taper again.
Therefore, dividing the year into two halves, there has been a reversal in the supply and demand relationship for US government bonds. Massive issuance and the Federal Reserve's selling have pushed interest rates significantly higher, reaching new highs for this year.
The rise in interest rates is due to supply and demand dynamics and not because the US economic outlook for the second half of the year has improved.
3. The Fed's big trouble
Another protagonist in the story is the Federal Reserve, which is now facing big trouble.
As mentioned earlier, since the 2008 financial crisis, the Federal Reserve has embarked on experimental quantitative easing, expanding its balance sheet nearly tenfold. It has grown from $1 trillion to nearly $10 trillion.
As a percentage of GDP, it has also expanded sixfold, rising from around 6% to a peak of 36%.
For the Federal Reserve, its liabilities are mainly linked to short-term interest rates, such as the benchmark federal funds rate, while its assets are mainly linked to long-term interest rates, such as Treasury bond rates and mortgage-backed security rates.
Under normal interest rate conditions, the continuous quantitative easing and balance sheet expansion not only boost the economy, promote employment, and raise asset prices, but also increase the wealth of U.S. residents. The Federal Reserve itself can even make a significant profit.
For example, in 2021, with a positive yield spread between long-term and short-term interest rates and an absolute balance sheet size near its historical high of nearly $10 trillion, the Federal Reserve made a profit of over $100 billion. Compared to its asset size of nearly $10 trillion, this corresponds to a positive interest differential of just over 1%.
It's truly magical, like black magic!
However, inflation has finally surged, and the Federal Reserve has been forced to raise interest rates significantly. The yield curve this year has entered a significant inversion. In the opposite direction, the Federal Reserve has begun to bleed.
In the first half of this year alone, it incurred losses of over $50 billion, and it is expected to have losses of over $100 billion for the whole year. This corresponds to a negative interest differential of just over 1%.
What is even more interesting is that:
The Federal Reserve's profits all go to the U.S. Treasury.
In the context of strong fiscal stimulus, the Federal Reserve's profits have added fuel to fiscal spending.
Therefore, logically, the Federal Reserve's losses should also be borne by the Treasury. In the substantial fiscal contraction that the United States will face now and in the future, the Federal Reserve's losses will be further shared with fiscal expenditure, adding fuel to the fire.
It turns out that black magic is a boomerang. It unexpectedly strikes oneself in the end!
4. Where is the way out?
[Baiguan: The author's detailed discussion on why she believes the current situation resembles the US economy in the 80s during Reagan’s term has been omitted.]
From the present perspective, the way out is similar:
The US fiscal policy will face substantial contraction, the US economy will experience a deep recession, and US bond interest rates will decline significantly.
The interest burden of US government debt will be similar to that of the 1980s. However, the Federal Reserve's extremely large balance sheet is facing a situation of substantial losses, which has never happened in history. Therefore, especially in the current predicament of the Federal Reserve, the necessity of a substantial interest rate cut is even greater. Only by substantially reducing interest rates and allowing the interest rate curve to return to a normal level can the substantial losses of the Federal Reserve be reversed.
This round the US dollar will continue to depreciate, perhaps for several years. Until the next major cycle of the US economy recovers.
Originally, I thought the turning point would be similar to the previous round [Baiguan: the US election in 1984], happening after the election. But McCarthy's dismissal yesterday made me realize that the turning point may have been advanced.
McCarthy was dismissed precisely because he abandoned his previous proposal to significantly cut fiscal spending and reached a compromise with the Biden administration to avoid a government shutdown. This may indicate an important turning point, as the United States internally has already realized that the undisciplined and overly stimulating fiscal policy is unsustainable, and the forces opposing this policy are gaining the upper hand.
If the financial markets also realize this, the panic selling of long-term US bonds and the buying of US dollars may reverse earlier. US bond interest rates and the US dollar may peak ahead of schedule.
In the comparable history mentioned earlier [Baiguan: back in the 1980s], the main competitor of the US economy, the object of US sanctions and pressures, and the world's largest surplus country that maintained interest rates significantly lower than the US dollar due to high surpluses was Japan. After the peak of the US dollar, Japan's currency and stock market experienced a super bull market. This time, it may be the renminbi and the Chinese stock market entering a bull market.
Baiguan: In the following sections, the author explains her belief that the Chinese Yuan and equities may enter a bull market after the current round of U.S. dollar peaking. To illustrate her viewpoint, she draws a comparison between China's current situation and Japan's economic growth and stock performance during the 70s and 80s when the U.S. implemented similar trade protection measures against Japan.
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