I want to make clear at the outset that this is a long-term strategy piece and not to be confused with looking at a near-term trading scenario. It is important to make that distinction before I get started. Looking at the big picture requires thinking about things in longer time frames than the next month or even quarter.
The events in Cyprus which took center stage last month were an admission by the ECB, the Fed and the IMF that there wasn't enough QE available to bailout the banking system if the currencies in question - the U.S. dollar (UUP) and the euro (FXE) were going to survive the debt deflation and knock-on effects from the derivative collapse that is occurring.
In order to finance part of this process depositors will pay part of the bill. There is a reason why deposit insurance is not unlimited and it is for moments in history just like this. That the Western monetary authorities thought it was a good idea to threaten insured depositors to scare them into circulating their money, thereby undoing more than 80 years of trust in government guarantees, should tell you something about the gravity of the situation.
In previous articles I've discussed the need for the international demand for dollars to remain as high as possible as both the reserve system breaks down and the use of dollars as the universal medium of exchange in international trade - especially that of oil and gold - breaks down. The TIC report has been very revealing in the hardball that is being played by the Fed to force China to buy more U.S. Treasuries after it antagonized Japan over the Senkaku/Diaoyu islands. This was a massive geopolitical error on China's part. Had they let that sleeping dog lie and continue strengthening ties with Japan, the Abe government would not have had to throw its hat back in the ring with the U.S. and engage now in very ill-advised, nearly biblical QE.
Another BRICS in the Wall
The recent BRICS Summit was notable for a number of things, not the least of which was the $30 billion currency swap arrangement between China and Brazil. Make no mistake, just like the similar deal struck between Japan and China last year, this is an important step in ensuring that the dollar is cut out of an ever-growing swath of international trade. While the summit ended without a firm commitment to a BRICS version of the World Bank, expect that to become a reality in the near future. At a minimum, expect stronger ties between these nations as the decade gets older.
Let's add into that the growing closeness of China with its ASEAN trading partners, exemplified by the nomination of ICBC as the clearing bank for yuan-denominated trade in Singapore. Previous to this, transactions had to be routed back through Hong Kong but now the process is streamlined and again, will cut the dollar slowly out of trade between Singapore and China.
In this respect I would expect the Singapore dollar (FXSG) to continue moving in sympathy with the yuan (CNY) than with the dollar or the euro. For all intents and purposes, the Singapore Dollar has been pegged to the Malaysian Ringgit at ~2.5 to 1 for nearly the past year. While the Ringgit itself trades very strongly with the Yuan.
This makes sense since Malaysia is Singapore's biggest trading partner and China is Malaysia's. To further facilitate this move away from the dollar and Western monetary control, China has developed the China ASEAN Electronics Clearing System (CHANCES) and guess which bank is the CHANCES representative across ASEAN? ICBC is.
Revenge will be SWIFT
When the U.S. pushed Iran out of the SWIFT system as a final bit of leverage to try and crush their adolescent nuclear program, it set in motion the current chain of events. China has moved brick by brick to remove itself from the dollar trade internationally.
The point here is that SWIFT is not that difficult to replicate and within four months of the Iran sanctions taking effect, China was deploying CHANCES across ASEAN. Now, let's add in the fact that gold and other commodities futures are trading in Shanghai and being settled in both yuan and dollars and that crude oil is next in line - presumably by the end of the year but possibly sooner. This is a direct threat to the petrodollar system and places even more pressure on the demand for dollars. With Russia and China laying the groundwork for Russia to supply the oil for the contract, you should be able to connect the dots as to where all of this is headed.
The Prevent Defense
This brings me to where we are today. There is a whiff of desperation in the air at the moment that is hard to ignore. Western monetary authorities are working extra hard to keep all hints of instability swept up under the rug. When I look at the big picture, I see falling structural demand for dollars that is being papered over by a mix of fear in Europe, historic debasement of the Japanese yen and ruthless suppression of the price of gold (GLD). The VIX is at an historic low and U.S. equities continue to shake off rising commodity inventories and worsening employment data.
Attempts at goosing money velocity to this point have been an abject failure and economic activity around the world is slowing down despite a tremendous amount of money having been printed. There is no way to remove this money without causing the entire banking system to collapse, so a mixture of QE and depositor impairment will be the order of the day as time goes along.
This is highly inflationary, as this money will move out of the currencies that are depreciating and will move into those that are or give a return above its home country's CPI, in effect, effecting a real yield. Some of it will flow into physical gold. And the more this system is revealed to be insolvent, the more people will trust the promise of gold in their hands rather than digits in their accounts. The ratio of M2 to M1 will collapse in structurally weak currencies.
In the U.S. currently this is the scenario we are facing. Falling M2/M1 - since M2 is M1 plus savings - is coupled with falling money velocity. The Fed has tried to scare savers to death but it hasn't worked. M2 velocity is still in free fall, as it has been since the turn of the millennium.
What this means is that the savings are not being deployed into the economy but rather being laundered out and transformed into some other form of savings. I have established in previous articles that the money is not flowing into Treasury bonds nor is it flowing into commodities - the CCI, if anything, has been signaling economic contraction for a while now. It is not flowing into paper gold either as ETF outflows have been very large - more than $7.3 billion in 2013.
The data and the headlines are pointing in one direction, that there is a serious problem lurking just beneath the surface of these currently calm waters which the records in the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA) are masking. The Fed is trapped. It cannot print money in the face of weakening international demand for dollars. But it needs to do so to fund the shenanigans in Washington D. C.
At this point, China has been willing to let the yuan slowly appreciate versus the dollar - now ¥6.20 - while soaking up some of the supply of Treasuries being created and buying gold to improve its hard asset backing. But, there will be a limit to how much China will absorb and as the yuan becomes more internationalized and the dollar less important to the Chinese economy. The news that Australia and China have launched direct trading of the yuan and the Aussie, cutting the dollar out of trade between them is very significant and will further marginalize the dollar in the region.
So, where are we now? We are at the stage of extreme defense of the dollar's position as both the world's reserve currency and as the dominant currency for settling international trade. The foundation is being laid every day which means that the Fed must continue on its current path of monetary debasement and scare tactics to project calm to the world. But, all is not calm. The key to projecting this calm, however, is a falling or unresponsive gold price and a rising stock market.
At some point the game will change and what happened in Cyprus will happen somewhere else and capital will continue to shift from West to East and the control over how that capital flows is transferred as well.