Provided below is a most interesting exchange between two professors. This theory, if true, would explain a few unusual trading patterns that we have witnessed recently.

Regards - VHF

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How China Will Handle the Yuan

Lance Lewis Aug 28, 2009 3:55 pm

I had this conversation with Professor Ryan Krueger and thought I'd share it with the rest of the community.

Lance Lewis: You notice the extra chunky volume in the Chinese Yuan ETF (CYB) yesterday at the same time that the dollar reversed violently?

Ryan Krueger: I do now. And the cash markets in beans are way above the futes even with this ramp job. Hmmm...

Lance: I’m telling ya. Something is up with China and the yuan. It would explain a lot. What if it were close to revaluing against the dollar?

We know it's fed up with funding US debt, but it can’t stop funding it as long as it continues to peg to the dollar and is forced to buy dollars every day in order to hold down the yuan. The US isn’t even its largest export market anymore. The EU is. The US consumer is broke. Why does China need to keep exporting cheap goods to the US if the US consumer can’t buy them anyway?

Now look at the recent market action in August. Normally when Chinese stocks go down, the dollar rallies and commodities get hit, just like in early August when people were betting on “the usual.” But this time, after the initial knee-jerk reaction to Chinese stocks sliding, “the usual” didn’t happen. Oil is now back on its highs. Gold is close to breaking out, and the dollar is back on its low for the year. And all of this is occurring even as Chinese stocks are back on their lows as of last night?

So, what’s good for gold, oil, etc., but bad for Chinese export stocks and the dollar?

China revaluing the yuan is the only thing that fits, and the US Treasury may even have an inkling that it’s coming, which would explain why Obama suddenly renominated Gentle Ben on a Tuesday in late August when he was supposedly on vacation. Rather odd timing, but not so if the intent was to remove as much uncertainty as possible as to who will be running the Federal Reserve going forward in order to prevent complete panic in the dollar and Treasuries if China were to one day say “I’ve had enough” to buying more dollars and Treasuries every single day in order to hold her dollar/yuan peg.

Ryan: True. And shooting against China already has somebody caught the wrong way on beans at the worst time. Perhaps the copper versus China disconnect also supports your revaluation-surprise theory as well? Chinese stocks would get clobbered, but copper would probably benefit.

Lance: Exactly! That’s my point. It’s the only thing that fits. If so, the dollar would get smoked, literally, “overnight” and gold would explode. Bonds would probably get crushed, too.

Ryan: My thought boils down to what would be the hardest trade here: Shoot against the hottest stock market this year in China by selling 'em; shoot against the obvious deflationary forces to say nothing of regulation fears in commodities by buying 'em. And, to top it off, shooting against the now consensus short-term view that “the USD can't go much lower and might rally hard from here” by selling it, too. If there was a surprise with the Chinese currency, I’d say the hard trades surprise a lot of people by working.

Lance: Yes, and working huge. But Chinese stocks would probably be a buy on that selloff though. They’ve already corrected a lot in front of it as if they “know.”

Ryan: I also agree, as I’m a long-term bull there, unlike many. But adjusting to currencies and growing pains will be part of that phenomenal growth.

Lance: Wal-Mart (WMT) would be in trouble. It probably wouldn’t be able to raise prices on all the cheap Chinese goods, and would likely have to just eat it with thinner margins. That would go for a lot of retailers actually, and their pain would be compounded by higher gasoline prices squeezing the consumer even more. What fun we’ll have.

Ryan: You just nailed the true trade and it's not a trade at all -- the rising standard of living that is happening there and shall continue. Doesn’t make US 'bad,' but on a relative basis we're already at an exceptionally high standard and I’d argue way too high for too many. It’s balance time.

Lance: Question is how smart are the Chinese? Dumb enough to keep printing yuan in order to hold it down versus the tidal wave of dollars that are crashing on her shores, and at the same time fund gargantuan US government-deficit spending out of the kindness of its heart? Or smart enough to say “enough!”

Ryan: Smarter than anyone wants to admit. After all, what’s been the best trade on the planet for the past 20 years? Treasuries. And they are about to make the next great trade, out of paper into hard, cycles cycle, or so I’ve noticed