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Thursday, July 06, 2006

Attention Mr Faber and Company

Interesting article courtesy of Mr. Santos, its a newsletter called "Outside the Box" by John Mauldin. In his newsletter he published this article by GaveKal Research called "The Leverage in the System and the Weak US$". In this article they linked crude oil demand and prices, petrodollars, currency bets and finally US$ and indirectly the US stock market.

What?!! How can all these things be clearly correlated? Well this article is certainly out of the box. To summarize for those people who are allergic to reading long and confusing documents, here it is. The article argues that countries need to have reserves of two things: crude oil reserves (since a lot of countries are short of oil) and central bank reserves (for international trade). Logic should dictate that if oil reserves go up, central bank reserves should go down as US$ must be used to buy this oil. However this is not happening... as oil reserves have been growing (due to higher prices and shortage), central bank reserves has also been growing the past few years! In the past year, central bank reserves grew 12%... so countries have been spending more on oil yet saving more US$?!! Has the US central bank been dumping US$ into the system? Is this the effect of the US current account deficit reaching new records?

There is a less obvious though very probable answer. It happened in the late 1970's and look like is happenning right now. Oil prices have increased, forcing some countries with current account deficits that are "short oil" to borrow large amounts in US$ to pay for the oil imports. Meanwhile, commentaries from Faber and the like, preaching about the demise of the US$ and the fiat currency and rampant inflation, are forcing the diversification of petrodollars. As a result, all these feed the perception that the US$ will fall further, forcing investors to make currency bets by borrowing even more US$ to buy assets in other currencies which they think will appreciate.

The large amounts of US$ borrowings can help explain the increase in central bank reserves. For example, data shows that 30% of China's US$ reserves are in the form of US$ borrowings, since the Rmb is widely expected to appreciate 5% this year. This builds up an increasingly "short" position on the US$ (investors have to sell the dollar to convert them to local currencies to buy assets) and any event that may tilt this massive imbalance the other way will force a rapid "covering" and thus appreciation of the dollar. It happened in 81-84 and 97-2000 (the US$ rose higher than expected due to the unwinding of US$ "shorts") and can happen again.

What can currently cause the shorts to unwind? Rising US interest rates, some increasingly weak emerging market currencies and the least likely an improvement in the US current account deficit. These events may take a while to happen, or they may never happen, but an increasing amount of bearishness on the dollar will increase their impact (potential rise in the US$) if ever they do. Just food for thought for Mr. Faber and company. Thus the US stock market may be weak or move sideways with all the problems they have with the economy but it may never crash. In short it all boils down to sentiment... high expectations, whether bullish or bearish, lead to even bigger disappointments!

TERENCE

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