The Shot Not Heard Around the World

China's recent move to devalue the yuan has sent shock waves through the global financial markets and has convinced most observers that a new front in the global currency wars has begun.

The move has caused many observers to envision a new round of competitive devaluations around the globe in which the race to the bottom will intensify. In this scenario they envision that the U.S. dollar will solidify its standing as the only strong currency. This misses the point entirely.

In the past, most of the action in the "currency wars" had been focused on the efforts that many nations undertook to prevent their currencies from rising against the U.S. dollar, which itself was being weakened by a perpetually easy Federal Reserve and persistently negative U.S. trade and budget deficits. But with the dollar now strengthening significantly, the Chinese government has become concerned that the yuan, which has remained largely tethered to the dollar, had become too strong against other currencies, particularly its primary trading partners in Asia and the Pacific. To remain competitive locally, it decided to ease the tether to the dollar and instead let its currency float more freely. The purpose and implications of this significant pivot has largely escaped the U.S. media. In reality, the move raises the likelihood that the yuan will rise significantly when the dollar resumes its long-term bear market, not that it will remain weak forever.

It is surprising how quickly market observers ascribed the recent losing streak on Wall Street to jitters over the 2% yuan devaluation. The development provided a convenient excuse for those who continue to deny that any economic weakness in the U.S. is chronic and self-generated. But why should America be so concerned with a small drop in the yuan? After all, we have supposedly done quite nicely for ourselves economically even while currencies like the yen and the euro, and all the other major currencies around the world, have fallen more than 20% against the dollar since May of last year.

In truth, the U.S. markets had been selling off for days before any change in policy from Beijing became remotely clear. With U.S. economic data deteriorating, corporate earnings falling, and 95% of economists forecasting a rate hike in the next few months, a sharp sell-off of already wildly valued stocks could be considered a logical development that needs no overseas explanations. But given that this is a reality that no one prefers to acknowledge, the yuan devaluation comes at a convenient time.

The last round of the currency wars began around 2010, when pronounced dollar weakness resulting from the Fed's Quantitative easing experiment and the Federal government's annual trillion dollar plus deficits had caused the dollar to fall sharply against most other major currencies except the yuan, which did not rise because the Chinese were enforcing a peg against the dollar. To affect the linkage, China had to accumulate trillions of U.S. dollar reserves, with the added benefit to America of keeping a lid on long-term interest rates and consumer prices, that would not have been there absent China's help. As a result, many currencies gained value against the dollar and yuan simultaneously. Faced with such scary prospects, many countries devalued to keep things in equilibrium; hence the race toward the bottom.

In contrast, I believe this time around Beijing was forced to act because the continuously surging dollar had been bringing the yuan along for an unwanted ride upward. This resulting movement against other currencies was not driven by fundamentals and put China at a disadvantage against its local trading partners.

By letting their currency float more freely, their principle concern was not their exchange rate with the dollar, which had remained largely fixed, but their exchange rates with currencies like the Japanese yen, the Australian dollar, the euro, the Canadian dollar, and other emerging market currencies in Latin America and South East Asia. This shows where the Chinese are placing their priorities.

While making its devaluation announcement, Beijing said that it wanted its currency "to reflect fundamentals" and to no longer simply mirror the movement of the dollar. It acknowledged the fact that its peg to the dollar was problematic and that it wanted a better, more natural mechanism. This is the key to understanding the announcement: The Chinese are preparing for a time in which the financial world does not spin in orbit around the dollar. Such a reality must make us think about the future.

Perhaps the Chinese feel as I do that the current dollar rise has all the earmarks of a classic bubble. After all, a major part of the dollar rally over the past year has been the hollow beliefs that the U.S. economy has fully recovered and that the Fed, in 2015 and 2016, will be able to raise interest rates and shrink its balance sheet substantially even while the world's other major central banks continue to deliver stimulus. If they see the fallacies that I do inherent in these naïve assumptions, they may be sparing a thought or two as to their best course of action if the dollar bear market resumes, as it surely must.

What will happen if current trends continue and the U.S. economy slips back toward recession? Any sober reading of the current economic data, which shows anemic investment, minimal productivity growth, barely positive GDP growth, wage stagnation, and falling labor participation, should allow for the strong possibility that recession is looming in the U.S. If it occurs, or to prevent it from occurring in an election year, the Fed will be forced to immediately shelve its tightening plans (if it even has any) and instead deliver another round of QE. When that occurs the confidence that inspired the dollar's rise will prove to have been misplaced, and the rally nothing more than another Fed-induced bubble.

By decoupling from the dollar now, China is sending a message that it may be prepared to let it fall later. This means that when the dollar starts to fall in earnest, China may not be there to catch it. This will also mean that the biggest foreign buyer of Treasury bonds will likely be sitting on its hands when deteriorating U.S. finances force the Treasury to begin issuing trillions of new bonds annually. So when the U.S. needs China's help the most, it will be unwilling to provide it.

In the absence of a Chinese backstop that the U.S. has for too long taken for granted, when the dollar resumes its decline, the fall will be much more pronounced. This will also generate significant upward pressure on both U.S. consumer prices and interest rates that was absent five years ago, when Chinese buying provided a huge cushion to the U.S. economy. In fact, data indicates that China is already paring the amount of Treasuries held in reserve. That means a full blown dollar crisis may not have been averted, but merely postponed, with the dire warnings of U.S. hyperinflation potentially coming true after all.

The move may also rekindle to the Chinese appreciation for gold as a safe haven asset as the yellow metal has surged in yuan terms over the past few weeks. Increased buying in China indicates that this may indeed be the case. Given the importance of gold to the typical Chinese investor, the yuan/gold exchange rate may become more important globally than the gold/dollar rate.

Peter Schiff is the CEO of Euro Pacific Capital. 

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commented 2015-08-16 19:16:27 -0400 · Flag
Spartacus commented

the governments Hand in Real Estate is Lasting, permanent and has comes with continuous cost escalation (howd’y partner)

We will All LOSE, the challenge ahead is to negate and minimize the level of losses to the extent possible in this corrupt, Freak Show.

I can hardly wait for Trumps proposed Treasury Secretary, Carl Ichan, to assume control … the absurd just becomes more stupefying with each passing moment !!
commented 2015-08-16 13:55:40 -0400 · Flag
B.P. commented

the ruse is so comically transparent that it is almost Dadaist…try getting ANY physical PM delivery ANYWHERE and it is impossible (outside of dealing with a top private bank in Switzerland, where it is still possible).
commented 2015-08-16 13:50:47 -0400 · Flag
Delroi commented

welcome to one of the most comically brazen manifestations of the complete destruction and corruption of western capital markets: the ‘price’ of paper precious metals versus actual physical price/demand. The markets A-Z are now an insult to anyone’s intelligence who has an inclination for one iota of honesty. True price discovery? That only exists now in blankfein’s and yellen’s bungholes.
commented 2015-08-16 13:50:02 -0400 · Flag
Vic. commented

Wonder what’s happening with silver supplies – I purchased some silver on July 17 – still has not been delivered – think there might be quite a tight supply of physical silver……
commented 2015-08-15 20:45:26 -0400 · Flag
A.A. commented

The only play right now is to hold cash positions. The big punch in the gut is eventually coming and it will take everything from real estate to commodities down with it. I simply do not have the stomach to lose big on any of those bets (including stocks which will also correct viciously), so the only play is to lose small with the ignominious cash pile play (and be raped with the negative interest rates for the moment) and still have most of your chips left when the smoke clears and you can pick under-valued assets from the rubble…
commented 2015-08-15 20:40:31 -0400 · Flag
V.M. commented

Completely agree with mid-market real estate play – problem is much real estate has over-corrected to upside. And it’s hard to buy real estate in many states given migration of population – and brutal increases in property taxes and income taxes especially at state level….
commented 2015-08-15 20:39:45 -0400 · Flag
Delroi commented

Well that’s the $64k question isn’t it. The fed and its oligarchic minions have very knowingly rendered every major investment option a casino in which one can’t responsibly invest, if one believes risk stalks reward and the entry price points of investments largely dictate the holder’s ultimate returns.

I’m BEYOND overweight precious metals and have zero plans to lighten up, but truth be told, I’m not adding either. My fact-based conviction has made me suffer enough, even if I do continue to believe it’s an interim condition.

Investments now? They’re ALL risibly over-priced, the artifact of the cornerstone asset price/reference for everything else (i.e. govt. yield curve) being feloniously and systematically mugged. Push comes to shove, if I had money I had to invest today I’d be looking at middle class-targeted productive real estate. Residential or commercial. Lots of businesses will be downsizing; lots of mcmansions will be vacating, with their previous occupants looking to downsize and rent. And yet, I’m the first to concede, if my broad theory is correct, my suggestion isn’t an easy one to effect.
commented 2015-08-15 20:38:18 -0400 · Flag
Richard commented

What do you recommend doing to prepare for this? Buy more gold? Is Gold a “Buy” now?

Are there any other hedges to prepare for the looming crisis brought on by our feckless spending?
commented 2015-08-15 20:37:33 -0400 · Flag
Delroi commented

Obvious to all who don’t have a status quo agenda to apologize/protect that the world is moving away from a $-centric monetary system. The dollar will remain a major reserve currency, but a less hegemonic one, a more equal partner in a basket of fiat quasi-equals. It is still the ‘cleanest’ dirty shirt, but its encroaching soiling is going to be felt as an irrefutable diminution of john q.public’s standard of living.

The petro-market and the commodities markets are going to increasingly be available and transactable in non-$ terms. The middle east, russia, china, asian basin, major latin countries have ALL made no secret of this.

In a decade people will be gob-smacked about the % of world trade done AWAY from the $. Steve leisman and the rest of the cocksmokers on cnbc are blithely dismissive of this. It’s as if they believe robert rubin and his chrony ilk have repealed the march of history and math.
commented 2015-08-15 12:25:03 -0400 · Flag
C.R. commented

Many investment advisors continue to cling to nearly universal BUY ratings, ignoring dire debt loads, static or contracting subscribers, declining revenue/subscribers, lower profitability margins, woeful returns on invested capital…I feel this autumn is going to be world-historic, in exposing wall street fantasists.
commented 2015-08-15 12:23:31 -0400 · Flag
Jim commented

Makes sense to me, esp. coupled with their move to support trading with Russia and other countries in their own currencies instead of in dollars.