China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

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This is the Most Important Inflation Chart in the World


The most important inflation chart to focus on right now is that of producer prices in China. It provides a depiction of what is happening with prices at the early stages of production in the largest net exporter nation.

China’s producer prices tend to filter into the rest of the world in the form of exported deflationary or inflationary pressures. After remaining deep in negative territory since early 2012 and registering a long string of consecutive contractions, China PPI has turned positive and is moving sharply higher.

It may only be a temporary spike to 7% that plateaus and then falls off as it did in 2011. According to the models I follow, which directly oppose the more traditional models used by many Keynesian economists, consumer price inflation is an input directly responsible for choking off economic gains. You can’t easily make raw commodities cost less but you can often replace labor with automation at a certain breakeven cost point. Thus, wage gains will struggle to keep up with input-cost led inflation, inflicting harmful economic damage when central banks get behind the curve rather than providing additional stimulus from “running the economy hot.”

In that sense, higher inflation may take care of itself by slowing down growth and threatening to let air out of the massive China credit bubble. Of course, monetary conditions should be tight enough to prevent the type of extreme credit expansion seen in China and elsewhere from happening in the first place. However, we are living in a Keynesian-dominated world of permanent bubble manufacturing after all. But what if the credit bubble doesn’t burst and producer prices keep rising?

If China PPI doesn’t level off very soon and it indeed surpasses 2011 levels, we have ourselves a potential black swan for 2017. Global consumer prices would certainly follow the China PPI trend with or without additional oil price gains (higher oil will only compound the problem). It is too early to know at this stage, but you should be watching the most important inflation chart in the world for further clues as new data is released out of China. We may eventually be headed for an inflationary spike followed by the bursting of the great credit bubble, in which China is at the epicenter.