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China’s inflation continues to worry markets

Last week was of course dominated by Europe and the extraordinary surge in the euro, which saw it climb against the dollar from a low of 1.2873, to end the week at 1.3387, with the twin catalysts of a better than expected debt auction in Portugal, coupled with a hawkish statement from ECB Governor Jean Claude Trichet, helping to propel the euro upwards, and taking out layered stops on the way! The Portuguese bond auction was oversubscribed, with a yield of 6.7%, below the threshold of 7% set by Lisbon as the trigger for a bailout packaged from the ECB and IMF. Governer Trichet’s comments startled the markets, as his robust statement made it clear that inflation was the top priority this year for the bank, and with inflation currently running at 2.2%, now above the bank’s target of 2%, he made it clear that interest rates would rise sooner rather than later, and as such the bank would not hesitate to act swiftly.

Whilst these were the headlines that dominated global forex markets for much of the week, in the Far East, and almost unnoticed, the People’s Bank of China, raised the Reserve Requirement Ratio or RRR once again by 50 bps, as it attempts to manage both liquidity and the rate of bank lending, which is driving inflation higher as a result. As such this was the fourth rate rise in a matter of weeks, and when it comes into effect next week, will take the rate for the major banks to a record 19%. Whilst Europe frets and worries inflation of 2.2%, and the UK worries at levels around 3.3%, China by contrast has inflation rates of 5% and rising, as it struggles to contain the housing bubble and consumer demand, along with higher prices. Last month of course the Bank raised it’s interest rates by 25 basis points, and now looks set to move towards using the RRR as it’s primary weapon in combating inflation, with several further rises expected later this year.

China of course is the world’s second largest economy, and as such provides a bell weather to traders and investors as to “risk on”, and “risk off” appetite, and last week’s news resulted in a sharp sell off in the dollar, along with the Aussie dollar and New Zealand dollar, with commodities also falling sharply on the news of further measures to control the economy. Meanwhile in the currency markets, China has allowed the Yuan to strengthen slightly in the last few weeks, but well short of US expectations and Mr Geithner in particular, who still consider the Chinese Yuan substantially and artificially undervalued. However, this issue aside, provided that inflation in China is kept in check and growth continues at the recent rate of 9.6%, then the wobble in ‘risk on’ sentiment, which saw the markets slide last week and equities struggle, should return, although as always, Europe will continue to dominate the week once more, as the EU Finance Ministers meeting gets underway on Monday with the US markets closed for Martin Luther King day.