Every market cycle has one to two macro drivers at the heart of its regime. We call these the fulcrum points. Keep an eye on the fulcrum and you will know when a major cyclic turn is underfoot.
The fulcrum point for the current cycle is without a doubt the U.S. dollar (UUP, Financial). The dollar is sitting on top of a $9-$11 trillion powder keg of foreign carry trades — essentially short-dollar positions. And the torch that is likely to set off this powder keg of deflation is the Chinese yuan (FXI, Financial).
A depreciating yuan equals a stronger dollar. A stronger dollar increases downside pressure on a depreciating yuan. This is called a feedback loop. Once the loop picks up momentum, it will rip until it has completely exhausted itself.
If (when) this loop starts up, the current market cycle will be over. We will enter a new bear regime. And if it is anything like past devaluations, the shift will be painful and dramatic.
With that said, investors should be concerned. The yuan has been on a relentless march lower against the dollar (when the yuan falls, the pair rises). It has been hitting new six-year lows almost daily and showing no sign of abating.
The yuan has fallen even further against other countries, over 30% just this year against currencies it competes with for exports. This is akin to a massive tectonic plate shift under the ocean. At the epicenter, things are hardly noticeable. But under the surface, powerful waves are barreling toward distant shores.
We are seeing ripples of this move in the dollar now. It has been strengthening the last two months and looks set to break out of its 18-month trading range.
Capital flows out of China have been picking up steam. Much of it is being disguised under other cross-border flows in an attempt by the Chinese Communist Party to hide the severity of the situation.
It’s no surprise the Chinese “smart money,” the wealthy and politically connected, are transferring their savings out of the country by going on an unprecedented acquisition spree of foreign companies.
Feedback loop gaining momentum. Fulcrum shift in motion. Cycle change coming.
The irony is that a devaluing yuan, once at the front of investors' concerns at the beginning of the year, has now faded to little more than an afterthought. But as the saying goes, the big moves happen when no one is looking.
Good thing we are.
Disclosure: The author owns no shares in any stocks mentioned in this article.
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