Excell with Options: Assess FX Impact of the Chinese growth story
Executive summary
In this issue, Rich analyzes China’s economic growth using indicators like China CPI, M2, and Total Social Financing, evaluating currency pairs and recommending a slightly bullish AUD/USD Strap strategy.
Image 1: China CPI, PPI, and M2 money supply growth
As a recent host of CFA Society Chicago Macro Matters podcast, I discussed the topic of Chinese growth. Market expectations were for China to experience a post-lockdown economic growth acceleration similar to the U.S. in late 2020 and 2021. The co-host, an expert on China, highlighted China’s objective to de-risk its economic growth by shifting away from reliance on exports and external growth, aiming for increased emphasis on domestic consumption.
The reality is that Chinese growth has not met expectations this year. Again, that became clear last week when China PMI came in barely above the 50 expansion/contraction level. On July 10, the Chinese economy received even more unfavorable news when CPI came in at zero percent. What does that mean? It means no inflation, which must be a good thing for consumption, right? Perhaps if it was thought to be temporary. However, if consumers believe deflation will take hold, they may defer consumption with the expectation that prices will still be lower in the future. Bernanke’s knowledge of the U.S. Great Depression led him to adopt an ultra-easy policy to combat deflation. Japan’s experience of struggling to get inflation above zero percent and usually below one percent for the past 30 years supports this, causing a growth slowdown.
The chart above shows China CPI in white, PPI in blue, and M2 money growth in purple. I drew vertical lines when CPI went below zero percent. Both times PPI was also deep in the negatives, which is where we are today. In 2009, this occurred with Chinese export partners struggling due to the Great Financial Crisis. It also happened in 2020 given the global Covid-19 lockdowns. The difference between these two situations was that in 2009 the government stimulated the economy and M2 money grew. It didn’t do that in 2020 so M2 growth actually shrank.
With a desire to drive domestic consumption, what will the Chinese government do now that CPI appears to be on the brink of deflation?
Image 2: China CPI, China M2, and Chinese Total Social Financing
The chart above is similar to the chart showing CPI and M2 growth, but with Chinese Total Social Financing growth included. This is often the preferred form of Chinese stimulus, but I can see that over the last year the growth of it has collapsed. Does this mean there is more capacity for the government to stimulate the economy? There are well known China strategists that suggest that Chinese stimulus may be the critical story for the market in the second half.
Image 3: China CPI, China M2, Chinese Total Social Financing, and AUD/USD
I have included the AUD/USD cross on the chart above. I can see that in the past, when there were moves higher in Chinese money growth and social financing, there was a move higher in AUD/USD. When these numbers decrease, it typically results in a sideways to lower trend for AUD/USD. If we see Chinese stimulus in the second half, does this set up for a bullish AUD/USD move?
Image 4: China CPI, China M2 growth, Chinese Total Social Financing, and USD/CNH
Here is the same chart as before but USD/CNH is included. The pattern is not as clear here, as USD/CNH moved in tandem with CPI in 2019-2022 but this year it has moved higher even though CPI has moved lower. The currency pair has become disconnected. In order to reconnect, one might expect USD/CNH to move lower. However, we can see that in some ways, CNH may be anticipating and leading the changes we see in M2 and TSF back in 2019, followed by a call in 2021 and a move higher in 2022. Does this mean that CNH might be signaling more stimulus to come?
Image 5: AUD/USD Currency pair and Li Keqiang Index
Former Premier of China Li Keqiang once said that measures such as GDP were man-made. In order to assess the economy, he preferred to look at railway cargo volume, electricity consumption, and loans disbursed by banks. The Economist created this index, which we can track it on Bloomberg. You can see that when this index of economic growth moves higher, the AUD/USD does too, then when it moves lower, the AUD/USD also tends to follow. This may feel intuitive to most traders, but I like to see this intuition corroborated in the data.