Goodwill not enough

China has demonstrated goodwill in the form of the Westinghouse deal, resumption of the six party talks with North Korea, promises of currency appreciation acceleration, and praise for all the homework done by the U.S. ahead of the summit. Goodwill is not enough, though.

China will probably not revalue fast enough to please the U.S. Congress, which will retaliate with tariff and other trade restraint bills. These may not pass, and if they do they may be vetoed by the President, but the rhetoric will poison the U.S.-China relationship.

The Office of the Trade Representative will, with regret, lodge its complaints with the WTO. China will probably establish its special-purpose reserve management fund along the lines of the Swiss agency, and diversify out of dollar assets or at least out of U.S. government bonds and Agency obligations. It is Paulson’s job to keep the financial “war” at a simmer and not on a boil, but he faces a nearly impossible task. Loud and angry words are on the horizon.

This scenario is the mainstream forecast for the upcoming year, and many think there’s a better than 50-50 chance of it actually occurring. As traders, we can easily make the mistake of attributing big-picture macro developments such as these to the immediate trading environment. That doesn’t always work.

However, the reserve diversification story is getting ripe now that the U.S.-China summit is over without hard and specific promises on both sides. Watch the news, not only for the pace of yuan appreciation but also the specific risk factors — tariffs, WTO cases, special Chinese reserve-management agency action — that will provide trading opportunities.

Because market sentiment is profoundly dollar-negative, good news on these issues will not necessarily boost the dollar, but bad news will certainly harm it.