>The Leverage in the System and the Weak US$

We always like to quote Bastiat and highlight that economics is all about what we see, but more importantly, what we do not see. Take consumer leverage as an example. For years, the perma-bores have warned us that the amount of leverage the US consumer was taking on invited an economic disaster. Instead, and despite numerous crisis (9/11, Iraq War, Enron, Sars, Katrina, Refco...), the US consumer has continued to do what he does best: consume. Most people did not see that the increase in leverage (what we saw) was made possible by the fall in the volatility of US economic growth (see Our Brave New World).

A worse trend, also prevalent amongst financial commentators, is to link two events that have strictly nothing to do with one another. Take this weekend's Financial Times headline: US Dollar Takes a Pounding Because of Current Account Deficit (then why doesn't the AU$? Or the GBP?). As our clients know, this is "non sequitur" if ever there was one and it is about as credible as the "interest rates go up because of the budget deficit" argument of a few years ago. The first part of the phrase is true (the US$ is falling), the second part of the statement is true (the US does run a current account deficit) but the link between the two is completely arbitrary (try finding a correlation between current account deficits and currencies). As our readers know, the truth of the matter is that the FT's headline is based on three premises, all of them wrong:

1. That imports and exports should balance over time. This is factually incorrect, the US has had a current account deficit for most of its History, except during a few years after WWII. This has not stopped the US from having a spectacular growth and a relatively stable currency. Moreover, looking at the past fifteen years, we find that the best performing OECD economies (UK, US, Australia, Spain) have run large deficits while the model students with the current account surpluses (Germany, Switzerland, Japan) have been economic laggards. So what is the point of surpluses?

2. That imports and exports have similar margins. Wrong again, if one imports cars and sells software, the margins are not the same. If the US trade balance were to be computed with profits and not with sales the US would have a huge surplus (see What Investors Should Know About the US Current Account Deficit).

3. That one should compare the deficit with the GDP. Wrong yet again. One should compare the deficit with the size of the assets that the foreigners can buy with their excess dollars. As Anatole tried to demonstrate to Steve Roach at the recent Morgan Stanley conference (see Do Imbalances Matter?), the current account deficit is miniscule when put in comparison with the size and the growth rate of the US assets.

But yet the US$ is today very weak. And if it is not the US current account deficit and the ever-forthcoming refusal of foreigners to fund the US' lavish lifestyle, what drives this weakness? And how long will it last?

This brings us back to what we see (the US$ falling, the large US current account deficits...) and what most do not see (the unwinding of the Yen carry trade, the buildup of large amounts of leverage in the system where it is the least monitored etc...).

1- The End of the Yen Carry Trade

We have argued for a while (see The Importance of Japanese Liquidity Flows, or the May Monthly Review...) that the combination of Japan's quantitative easing policy + zero interest rate policy + FX stabilization policy, led to a massive export of capital by Japan to the rest of the world, to an enormous bull market in fixed income everywhere (see Of Bonds and Zombies) and from there, to a bull market in most asset classes (real estate, distressed debt, equities...).

As Japanese authorities pumped money into the system, told investors they could take money for free and re-assured everyone not to worry about potential swings in the value of the Yen, the Yen remained under pressure and stayed far below its purchasing parity against the US$ and Euro.

In our research, we argued that Western central banks could not hope to tighten monetary policy while Japan's three policies (QE, ZIRP, FX stabilization) remained in place. In other words, their tightening efforts would always be negated by Japan's easy and free money. This meant that if Western central banks were serious about removing excess liquidity from the system, they would have to start leaning heavily on Asia's central banks (see The BoJ in the Line of Fire).

And sure enough, this is what happened last month at the G7 meeting. Following its pledge to abandon its policy of quantitative easing (note the collapse in the growth rate of Japanese monetary base-and note the dates previous collapses occurred), Japan seems to have abandoned its policy of FX stabilization. Indeed, the Yen has rallied very violently from Y118 to Y109 without as much of a pip from the MoF or the BoJ.

Now interestingly, the markets initially seemed to brush-off the Yen's rise. But when the Yen passed Y110/US$ last Friday, it was as if someone had cried "fire" in the proverbial over-crowded theatre. Or, as our friend Dennis Gartman likes to say, all of a sudden at Y110/US$, the "margin-clerks took over from the money managers".

And this brings us to a first observation: recent events in the financial markets have had less to do with US$ weakness (hence the stupidity of the FT's headlines) as with strength in the Yen. Indeed, unlike 2004 when the US$ was falling against every currency, this time around, the US$ is falling, but a number of Emerging Market "risky" currency (which had done so well in 2004) are falling even faster. In the past week, against the US$, the Turkish Lira has fallen -13%. Yesterday alone, the Indonesian Ruppiah fell -3.7%, the RSA Rand fell -3% (despite high gold prices), the Polish Zloty lost -1.9%... Undeniably the margin clerks are back in charge and the yen carry trade is being unwound.

So far, so good. And without wanting to crow, we would say that the above developments made sense and seemed to go "according to plan". Apart from one factor: the impressive rise in the Euro (and other European currencies).

2- Listening to Outliers

Given the end of the Yen carry trade, and the mini-squeeze currently happening in financial markets, the rise of the Euro came (as our readers know) as a large surprise. And it is by studying the "surprises" (a pleasant euphemism for mistakes) that one usually finds the most interesting information. Indeed, our work is based on the study of historical relationships, and the application of logic. And when historical relationships and/or logic fails it is usually that something "new" or something "different" is happening. This is why we never shy away from saying that "things are different this time"; as expensive as these words might be, they are a whole heck of a lot cheaper than saying "things are always the same"!

Having said that, looking at the Euro's recent rise, we are inclined to conclude that there is little difference this time. In fact, the situation is very similar to the situation we experienced in the late 1970s. Let us explain.

3- Two Pools of Reserves

Let us start with a few undisputable facts:

Fact #1: Most countries in the World, especially modern developed countries are "short oil"; they do not produce enough oil domestically to meet their needs.

Fact #2: Oil is priced in US$. In fact, since the end of WWII, the US$ has been by and large the recognized currency of international trade. When France buys oil from Algeria, the barrels are quoted in US$. When China buys tin from Malaysia, US$ are exchanged. If Nokia buys chips in Taiwan, the chips are priced in US$...

Fact #3: Given that the world needs US$ to trade, the US is sort of forced to run a current account deficit and export US$ (otherwise, how would Nokia get the US$ to fund its purchases in Taiwan?). This explains why improvements in the US current account deficit usually lead to global economic meltdowns somewhere in the world - all of a sudden, there are not enough US$ to go around (see What Investors Should Know About the US Current Account Deficit) and entire countries can be found "short US$".

Putting the above three facts together, it makes sense that countries whose daily activities cause them to be "short oil" and "short the US$" will want to store either one, or both, to prevent any financial accident from happening. Consequently, we can say that we have two large pool of US$ liquidity in the world at any one time: a pool of oil reserves, and a pool of US$ reserves

These two pools of reserves are of course interconnected and the best way to envision is to imagine a scale on which you place two reservoirs. One reservoir is full of money, and the other reservoir is full oil. Now if the "oil reservoir" starts to cost more (i.e.: move up on the scale) then all else being equal the "money reservoir" should go down. Of course, all else is not equal. If nothing else, the "money reservoir" is fed at all times by the US current account deficit. And this is where it gets interesting.

4- Oil & the US$

As things stand, the World consumes around 85 millions barrels of oil per day. And as we all know (but unfortunately, as we did not foresee), the price of oil has jumped by US$25/bl over the past 12 months. So, if nothing else, the "dollar working capital needs" of the world must have increased by approximately US$775bn (85m barrels of oil * 365days *25 US$). So point #1: given the increase in oil prices, the world needs an extra US$775bn (and note that we do not even go into the need for extra US$ because of higher metal prices, higher soft commodity prices, rapidly growing global trade etc...).

Now let us assume that the world's oil inventories (whether on ships, in refineries, in the SPR...) have stayed more or less flat at around 100 days of consumption. Then the financing of this excess inventory alone costs the world US$212bn (100 days*US$25*85m barrels). So simply between the rise in oil prices, and the rise in the costs of keeping oil inventories, the demand for US$ will have increased by around US$1,000 billion. And with this rising demand, one might have expected (we did!) a rising price for the US$. One might also have expected (we also did!) that the need for US$ will have lead to a reduction in central bank reserves. Indeed, as illustrated in the diagram above, higher oil prices typically lead to weaker central bank reserves. But as we know, central bank reserves did not shrink in late 2005 and early 2006 (against our expectations). Far from it: they continued growing by over 12% per annum or US$ 220bn in the past year.

Putting it together, this means that:

A) Demand for US$ resulting from oil has increased by US$1000bn in the past twelve months.

B) Reserves have grown by US$

So in other words, in the past twelve months, the World has spent more dollars, and saved more dollars than ever before. How is this possible?

Did the US central bank dump US$ into the system? Not really.

Did the US consumer push an enormous amount of US$ outside of the US through the current account deficit, hereby allowing for the simultaneous use of dollars and saving of dollars? Not to this extent.

Did the world go out and borrow US$ in size to pay for its oil? Now here is an idea that works! And not only does it work; we have seen it before.

5- Oil & US$ Borrowing in the Late 1970s

In 1979, we experience the Second Oil Shock. At the same time, the general perception in the market was that the United States could not be trusted to keep the US$ as a store of value. Inflation ran rampant and "cash was trash".

With the second oil shock, large amounts of petrodollars fell unto a number of countries and financial participants (Saudi Arabia, Nigeria, Venezuela...) who had neither the skills nor the infrastructure to deal with such amounts. Consequently, large amounts were deposited into OECD bank accounts (Citigroup, JP Morgan, BNP...). These banks immediately turned around and lent the money to countries which had been put in difficulty by the rise in oil prices, and thus had current account deficits (Brazil, Mexico...). It was called recycling the petrodollars.

To justify these policies, the chairman of Citibank (Walter Wriston) reassuringly told investors that countries do not go bankrupt. And sure enough, the trade worked for quite a while: the US$ declined steadily (partly because the dollar recipients were constantly "diversifying" outside of the greenback) and commodities kept rising.

However, one day Mr. Volcker came in and put US short rates at 20%. And, of course, the US current account deficit swung into surplus as US consumers tightened their belt. As this happened, we found that the World not only had an inherent short position on oil; it also had a short position on the US$.

And sure enough, the countries who had borrowed the US$ could not afford the new rates anymore than they could afford the oil prices. They went bankrupt (Mexico first, the rest of Latin America afterwards), and Western commercial banks found themselves on the hook. The commercial banks "rescheduled the loans" which allowed them not to go bankrupt, officially. But, on a cash flow basis, the OECD commercial banks were in fact short the dollar by an amount equivalent to the defaults. They had to purchase the dollar back, regardless of its price and the dollar exchange rate happily doubled from �81 to '84 on the simple necessity to cover a short position which had been established inadvertently.

Incidentally, this is why markets can be violently irrational, and for a long time, simply as an echo of a phenomenon which took place quite a while before and that everybody has forgotten. Markets have memories, and these memories are the positions that have been established in a different period and cannot be disclosed for fear of a run on the institutions which have these wrong positions. But these positions must be liquidated and adjusted nevertheless, and it takes a long, long time...

We had an echo of this very same phenomenon in Asia in the period 1995 to 2000. In 1995, everyone was convinced that the THB, MYR, KRW were massively undervalued and due a large revaluation. Everyone borrowed US$ (since rates were cheaper than local rates) to finance local projects (usually real estate). As money continued to plow in, returns on capital weakened. Soon the returns on capital moved below its cost and Asian currencies were forced to devalue. Asian banks, and the OECD banks that had lent to them, found themselves de facto "short the US$". As Asia repaid its US$ borrowing in the period 1997-2000, the US$ rose higher than anyone expected (including ourselves) and central bank reserves barely grew (despite large current account deficits).

6- Today's Short US$ Position

Over the past year, we have bored clients repetitively with the chart below:

The grey bars represent the annual increase in China's FDI plus China's trade surplus; basically the US$ billion amount that China earns any given year. The red lines represent the annual increase in reserves, or the US$ billion amount that China saves any given year.

As our reader will not fail to notice, something a bit odd started to happen in 2001: China started saving substantially more money than it was earning. An odd fact from which we could only draw the following conclusions:

A) Large amounts of capital found its way to China through unofficial channels (although Macao's growth would have led us to the opposite conclusion!).

B) Chinese and foreigners were betting on a revaluation of the RMB by borrowing US$ and buying RMB assets (real estate, factories...).

Having ourselves participated in such trades (i.e.: buying Beijing apartments with 80% variable rate mortgages in US$), our natural inclination was to think that the explanation might lay there. And in recent weeks, our theory that China has been building up short term US$ borrowing was confirmed by the government who declared: "China's short-term foreign debt far exceeds the level deemed safe by international standards, raising the risk of insolvency for some companies... At the end of 2005, China's outstanding foreign debt totaled $281.05 billion, a 13.6% increase from the year earlier (or an amount equivalent to 32.8% of China's total reserves)...". So according to the government, nearly a third of China's reserves can be accounted for by short term US$ debt. And we would venture to say that the Chinese have not been the only ones to borrow US$ to play the "inevitable decline" of the US$ (remember that in 1980, this was also the perception).

In recent years, we have seen large amounts of US$ borrowing taking place outside of the US. This means that an improvement in the US current account deficit could trigger a massive economic crisis; all the guys who are short would find themselves unable to earn the US$ to service their debt. So policy makers should be careful what they wish for... for if they get it, they won't like it!

Still, we hear our clients say, this is all well and good... but it does not help explain the recent meteoric rise in the Euro! But hopefully, this might.

7- The Impact on the Euro

As we have highlighted above, higher oil prices make for a much higher demand for US$. But of course the US$ also end up in someone's pocket.

Destination #1: Rational and professional investors. When the second oil shock hit the World, most oil producers were not organized to adequately absorb the wall of money that fell onto their (still small) economies. This time around, however, a number of countries have improved their financial infrastructure substantially (growth of ADIA, SAMA, KIF etc...). These professional investors will know that cash in US$ is their source of fund (since it comes from oil). So it makes perfect sense for them to try and diversify away from the US$ (since that is what they earn and will continue earning). So for the cash that befalls them, they can find the following use: a) other currencies (the US$ thus falls). b) global bonds (so the negative correlation between oil and bonds breaks down), c) global equities (so stocks do well, especially the more illiquid ones who benefit disproportionately from liquidity flows), d) other commodities and gold.

Destination #2: Russian oligarchs. The destination of choice for the money here is either their local market (Russian equities and bonds power ahead), Swiss banks (and the CHF/Euro rise), or the UK (the GBP and London property prices go through the roof). Little of that money makes its way back into the United States partly because of distance (the US is much further than Europe) and partly because the US is too often a hassle for private investors to deploy money in (forms to fill in, capital gains taxes, dividend income taxes etc...).

Destination #3: Shady Characters. Unfortunately, we live in a world in which rising oil prices mean higher revenues for shady characters. And we do not mean Louis' in-laws in Oklahoma but places like Venezuela, Iran... These countries, as soon as they receive their US$, will feel a strong urge to sell them and buy Euros, Gold, Sterling or anything else which does not have a picture of George Washington attached to it. Most probably, these monies will stay in bank accounts (Iran), or be invested in silly projects (Venezuela). In any event, the returns on invested capital of that money will likely be low...

So putting it all together, we currently have a nice merry-go round in the financial markets whereas:

1) Oil prices increase, leading to

2) Large US$ borrowing from oil importers to pay for the rise in oil, so

3) Large amounts of "borrowed US$" are received by oil producers who

4) Sell the US$ either for rational diversification or irrational policy, leading to

5) A growing perception that the US$ can only fall, which, in turn re-enforces the willingness to borrow US$ (Point #2)... and off we go around the merry-go round again.

8- How Do We Stop the Merry-Go Round?

The first option is of course that the oil price starts to decline, hereby a) making it less necessary for non-oil countries to borrow US$ and b) pushing less money into the pockets described above.

The second option is that the cost of capital in the US continues to rise to the point where servicing US$ debt starts to become ever more costly. On this point we would note that, if one is a Chinese producer and one feels that the RMB will rise by 5% a year for a long while, then the cost of capital in the US is nowhere near a level which would discourage US$ borrowing. However, after the past week, can a Turkish producer say the same thing? Or an Indonesian producer? Or a South African producer? All these guys might not be as convinced as they were a few weeks ago that the US$ can only go down (for them, lately, it hasn't!).

The bottom line is that oil consumers around the World have decided to postpone as much as they could the moment of reckoning which the increase in oil prices should have triggered. They have decided to borrow dollars (or yens?) to buy oil. As a result, a number of countries are now not only short oil, but are increasingly short the dollar. This means that, slowly but surely, we are building a corner on the US dollar similar to the one we built in the period from 1978 to 1980, or from 1995-97...

To discover the guilty parties, simply look at the last two pages of The Economist, and check which oil importing countries run large current account deficits (Turkey, Poland, Hungary, Slovakia...). As a rule, also avoid the countries with an overvalued exchange rate according to purchasing parity, and/or fixed exchange rates (Euroland, UK, Australia, New Zealand...). Maintaining an overvalued exchange rate by borrowing abroad is a time honored tradition for incompetent governments. It always ends in tears (Argentina, Korea, Mr. Major in the UK...).

As far as the oil producers are concerned, they are getting far more dollars than they expected. So they diversify these excess dollars either irrationally, or rationally. But they do not realize that a lot of the dollars that they are getting are not "earned" dollars, but "borrowed" dollars (see the increased indebtedness of Chinese companies, or individuals in US dollars as an example). As a result, US assets have underperformed the rest of the world assets for no valid reason at all. As soon as the flow of money to these countries will dry, the US assets will go up versus the other assets. This is a very good opportunity to start accumulating assets with positive cash flows in US dollars.

By GaveKal Research


Falkor said...

A good article. But Gavekal are the same guys who were bullish on dollar few months back. Is it thier new stand?

james said...

If china and all the countries and all investors the world over shun the dollar this will be very bad news for the united states. Interest rates would rise and the federal reserve would be forced to buy bonds from the treasury to fund the government and pay interest on all of the governments bills notes and bonds. When the buyers for united states debt obligations disappears the whole system will come crashing down. This is the type of thing that peter shiff has been warning everyone about when the ability of the united states to pay its debts becomes clearly in doubt all the buyers for united states debt securities disappears overnight.