Risk Trade Softens

Chinese Tightening Weighs On Global Markets

Last week's gains in commodities and growth sensitive currencies came to a halt over the weekend after the People's Bank of China announced that it had raised bank reserve requirements. The central bank lifted borrowing ratios by half a percent, causing the Shanghai Composite stock index to drop almost three percent. Cautious traders trimmed risk positions globally, and the US dollar gained slightly on a trade weighted basis.
After rallying almost four percent last week, the euro slipped in advance of a meeting between European finance ministers today as short covering lost momentum. The group of finance ministers is also expected to work on new rules for future budget deficits while discussing the mechanics behind a permanent aid facility. According to multiple news outlets, Germany is beginning to soften on the idea of increasing its contribution to the sovereign rescue fund and may be considering further fiscal union with the rest of the eurozone.
While weak growth will continue to weigh on investor sentiment, further economic integration could prove decisive in changing perceptions on the euro, while discord would set the exchange rate back on a downward path.
Volumes on North American markets will be light over this trading cycle, with US traders off for Martin Luther King Jr. Day. Consumer spending bellwether Apple will release fourth quarter results tomorrow, providing markets with plenty to chew on.
Bank of Canada Announcement Looms Over Loonie
North of the border, traders are preparing for tomorrow's statement from the Bank of Canada. Few expect the Bank to hike rates tomorrow, but expectations are sharply divided on what will happen farther out. Swap markets have priced in a rate hike by the end of May, and the Bank is expected to raise its forecasts for both the US and Canadian economies in the accompanying statement.
The Canadian dollar continues to pivot around the 0.99 mark against the US dollar, constrained within a relatively tight 100 basis point trading range for much of the last week.
Looking at fourth quarter data for 2010, the Canadian economy appears to have favourable momentum behind it. Trade numbers seem to be improving with US demand, and employment figures have been remarkably stable. High commodity prices are supporting export revenues.
At the same time, the Canadian economy does face challenges. Government stimulus spending is beginning to wind down, and the exchange rate is high enough to damage exporter competitiveness. 
Consumer debt levels are elevated, although recent developments would suggest that Finance Minister Flaherty will soon announce tighter mortgage lending rules in order to directly target consumer borrowing – potentially later today. If this occurs, the Bank would be left to focus on achieving inflation targets more directly.
Brazil Gets Real, Intervenes in Currency Markets Again
In yet another attempt to weaken the real, Brazil’s central bank auctioned $1 billion in reverse currency swaps over the weekend. A reverse swap pays investors overnight interbank rates in reals in exchange for fixed dollar interest rates. The real fell almost a cent against the US dollar as traders assessed the bank’s commitment to holding the currency below the 1.65 level. The central bank has become one of the world’s most active, intervening repeatedly to sell the real against the US dollar. At the same time, Finance Minister Guido Mantegna has authorized the country’s sovereign wealth fund to buy dollars in the futures markets and has tripled taxes on foreign bond purchases.
Mantegna’s shootout with foreign investors and speculators is only one of many occurring in the emerging markets. Responding to a surge of speculative capital from the developed world, at least a dozen countries are attempting to devalue their own currencies relative to their competitors and the US dollar, with varying degrees of success.
Unfortunately, this means that investors are simply going farther afield, pushing capital into countries that would have been considered incredibly risky only two years ago. As the World Bank put it in a recent report, “many of these flows are short lived, volatile and sometimes speculative in nature. Left unchecked, such flows can lead to abrupt real appreciations and depreciations that are out of line with underlying fundamentals and can do lasting damage to economies.” The risk of an emerging market unwind is growing rapidly.
Hu's On First
In advance of his meeting with President Obama later this week, Chinese President Hu Jintao said that "the current international currency system is the product of the past," signalling his country's desire to see the US dollar balanced by other currencies in the years ahead. According to interviews published by the Wall Street Journal and the Washington Post over the weekend (email us for links), President Hu indicated that moves to expand the renminbi's international role will continue. He said "China has made important contribution to the world economy in terms of total economic output and trade, and the renminbi has played a role in the world economic development. But making the renminbi an international currency will be a fairly long process."
President Hu reiterated concerns about the Federal Reserve's quantitative easing programmes, saying that US monetary policy "has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level." Along with many other emerging countries, China has seen much of this liquidity flow into domestic investment markets, causing sharp price rises and economic misallocations. 
In discussions about Chinese inflation levels, Hu said that the problem is "on the whole moderate and controllable. We have the confidence, conditions and ability to stabilize the overall price level." He dismissed expectations that the yuan-dollar exchange rate would be increased in an effort to pressure prices, saying "inflation can hardly be the main factor in determining the exchange rate policy."
China has hiked interest rates and tightened bank lending ratios repeatedly over the last year, and is widely expected to continue doing so over the next six months. This ongoing effort represents one of the largest risks for commodity prices (and the Canadian dollar by proxy) over the months ahead. China has become the world’s largest marginal buyer of raw materials and has a significant effect on demand in many other emerging markets. Bulls are hoping that President Hu’s confidence in China’s macroprudential policies is well placed.