By Clif Droke, Jul 20, 2016
One of America’s most prominent hedge fund managers is betting the farm that China’s economic troubles are far from over. His bet centers around the U.S. dollar and by extension several Asian currencies. What happens to the dollar from here will determine whether this man’s epic trading positions pays off, and China suffers a major setback, and whether his worst case scenario for the global economic outlook is merely a mirage. If he’s right, the outcome of his bet will also affect the commodities market and perhaps even the equities market.
Below is a graph of the PowerShares U.S. Dollar Index Bullish Fund (UUP), an excellent proxy for the U.S. dollar index. UUP is useful since it allows us to see trading volume patterns, particularly since UUP is a favorite of institutional currency traders. The graph shows that UUP has been establishing a short-term base of support above its rising 15-day moving average for the first time this year. The recent breakout attempt above the nearest pivotal chart benchmark at the 25.00 level technically paves the way for a dollar rally, which may in turn create some short-term headwind for equities.
A decisive breakout above the 25.00 level in UUP would allow the ETF to retrace more of its losses from past months. Any rally in the dollar from here would also put a bit of a strain on some of the major foreign currencies, which in turn would cause global investors to become more apprehensive. One reason for bringing up the dollar is the famous bet made by the billionaire hedge fund manager Kyle Bass. Bass made headlines when he correctly predicted the 2008 credit crash, and he has made another big short trade against China.
According to the Wall Street Journal, Bass’s Hayman Capital Management sold off the bulk of its investments in stocks, commodities and bonds so it can focus on shorting Asian currencies, including the yuan and the Hong Kong dollar. “About 85% of Hayman Capital’s portfolio is now invested in trades that are expected to pay off if the yuan and Hong Kong dollar depreciate over the next three years – a bet with billions of dollars on the line, including borrowed money,” according to the WSJ. “’When you talk about orders of magnitude, this is much larger than the subprime crisis,’ said Mr. Bass, who believes the yuan could fall as much as 40% in that period.”
In an interview on FOX Business Network’s Wall Street Week on Apr. 15, Bass clarified his investment position:
“So we have all of our focus on Asia. We don’t have any money invested in Asia. What we have is, we’re long the dollar, the U.S. dollar. And we’re betting against the Chinese currency, i.e. If we’re right about the banking crisis and we’re right about the fact that they’re going to do everything that it takes to fix themselves, which they will. They’ll recap their banks. They’ll reform, everything they can do on the spending side. They’ll…do everything they have to do….What that means, their currency is going to have a massive devaluation.”
Essentially, Bass is betting that Asian currencies will fall while the U.S. dollar will strengthen. For much of 2016 his bet didn’t pay off, but things are starting to go a little more in his direction. What’s more, his investment time frame is long enough to allow him leeway to ride through periods of dollar weakness and Asian currency strength. Incidentally, here’s what the yuan trend looks like through the lens of the WisdomTree Chinese Yuan Strategy Fund ETF (CYB).
In a July 1 interview on Real Vision, Bass told investors that China’s $3 trillion corporate bond market is “freezing up” amid rising defaults and canceled debt sales. “We’re starting to see the beginning of the Chinese machine literally break down,” he said.
China’s corporate bond market contracted by a record amount in May as tepid economic growth and a spate of missed payments spooked investors. Seventeen publicly-traded Chinese bonds have defaulted so far this year, up from six in 2015, and at least 188 firms have scrapped or delayed debt sales since the end of March, according to Bloomberg. See graph below.
In the Real Vision interview, Bass reiterated that China’s lending binge in recent years has created “the largest macro imbalance in world history.” He expects bank losses of $3 trillion to trigger a bailout, with the central bank slashing reserve requirements, cutting the deposit rate to zero and expanding its balance sheet – all of which will weigh on the yuan.
Bass doesn’t believe that China will experience Armageddon, however. “They are going to [recapitalize] the banks, they are going to expand the People’s Bank of China’s balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going to do everything the United States did in our crisis,” he said.
Bass and his hedge fund have had a rough go for the last couple of years. If the dollar manages to get a rally started in the coming months, however, he would have a measure of revenge against his many critics who contend that China is in much better shape than Bass contends. A dollar rally may also have the spillover effect of at least temporarily putting a drag on the stock market’s rally.
As mentioned previously, in 2016 more than ever the global financial outlook depends on the prevailing trend of the U.S. dollar. Since last year the dollar’s strength has been inextricably tied to global market weakness while dollar weakness has led to stock/commodity market strength. A breakout in the dollar index below its benchmark chart resistance (highlighted below) would serve as a harbinger of returning U.S. currency strength and potential weakness for commodities and possibly equities. It would give the China bears like Kyle Bass their moment in the sun.
Kyle Bass’s “revenge” is no private matter but something that concerns all investors. For that reason, what happens to the dollar from here will take on added significance.
This article is written by Clif Droke and with his kind permission, Gecko Research has been privileged to publish his work on our website. To find out more about clifdroke.com, please visit: