A trade pact between China and Germany is the latest in a series of blows to the US dollar as reported on Friday by Bloomberg - Bundesbank, PBOC in Pact to Turn Frankfurt Into Renminbi Hub (1):
Germany's Bundesbank and the Peopleâs Bank of China agreed to cooperate in the clearing and settling of payments in renminbi, paving the way for Frankfurt to corner a share of the offshore market.
The central banks signed a memorandum of understanding in Berlin today, when Chinese President Xi Jinping met German Chancellor Angela Merkel, the Frankfurt-based Bundesbank said in an e-mailed statement.
Germany's financial capital prevailed over Paris and Luxembourg in a euro-area race to win trade in renminbi, which overtook the euro to become the second-most used currency in global trade finance in October, according to the Society for Worldwide Interbank Financial Telecommunication. The U.K. Treasury said on March 26 that the Bank of England would sign an initial agreement with the PBOC on March 31 to clear and settle yuan transactions in London.
Read that again if you missed it. What it says is that the renminbi has overtaken the euro in global trade settlements and now is positioned ahead of all currencies except the US dollar. I have been reporting on this highly significant paradigm shift for more than a year now and at this point it would appear my warnings were well founded. There are two very significant events scheduled in the next few weeks that seem certain to move us closer to the end of the dollar's reign as the world's reserve currency.
The first one is the almost certain agreement between China and Russia on their own trade pact on Russian natural gas sales to China that will not be denominated in US dollars. Here is how Reuters explains the upcoming trade pact:
Forcing home the symbolism of his trip, Igor Sechin gathered media in Tokyo the next day to warn Western governments that more sanctions over Moscow's seizure of the Black Sea peninsula from Ukraine would be counter-productive.
The underlying message from the head of Russia's biggest oil company, Rosneft, was clear: If Europe and the United States isolate Russia, Moscow will look East for new business, energy deals, military contracts and political alliances.
The Holy Grail for Moscow is a natural gas supply deal with China that is apparently now close after years of negotiations. If it can be signed when Putin visits China in May, he will be able to hold it up to show that global power has shifted eastwards and he does not need the West.
Certainly this is not - as yet - a fait accompli as the US dollar is still the dominant player in international trade as Reuters explains here:
The market share of yuan usage in trade finance, or Letters of Credit and Collection, grew to 8.66 percent in October 2013. That improved from 1.89 percent in January 2012.
The yuan, also known as the renminbi, now ranks behind the U.S. dollar, which remains the leading currency with a share of 81.08 percent.
Notwithstanding the fact that the US dollar - for the moment - is still way out in front on this matter the trend seems clear and the pace to dethrone the dollar could accelerate even faster when the G20 countries convene in early April as reported here by the WSJ:
Is there disagreement in Congress on the governance issue?
Not so much. Unlike the IMF financing, there appears to be broad support for giving emerging markets more say at the fund.
So if there's support for the governance changes, but not the financing, why not approve one without the other?
Because the 2010 agreement dealt with the two issues together, and that is what has been ratified by scores of governments around the world. If the financing isn't ratified by the U.S., then governance changes can't be triggered. It would essentially require a new deal to be negotiated, and then approved, by more than 150 countries that require such approvals. That process that could take several more years.
That, too, would be viewed by many economists as a blow to the fund's-and Washington's-credibility. By failing to approve the deal the U.S. has already done "substantial, actual damage to the U.S. reputation around the world, as the leaders of many countries called into question Washington's ability to deliver on promises made in international economic agreements," Mr. Truman said.
Is the clock ticking?
The other members of the IMF have set an informal deadline: the IMF's semi-annual meeting April 11-13, when finance ministers and central bankers from the fund's 188 member countries gather to discuss the future of the global economy. They say they'll begin looking at alternatives if the U.S. hasn't cleared its piece of the deal by then.
Could we see fireworks at the G20 next week? It seems almost certain at this point that the US has no intention of relenting on the matter in the coming week so the next question - what will the other member countries do in response?
Is this really that big a deal though? Some seem to think so. Consider these recent comments by Jim Sinclair found here:
World renowned gold expert Jim Sinclair is issuing a warning of a massive downside risk to U.S. sanctions against Russia. Sinclair says watch the "struggling dollar" and Russia accepting any currency for oil and natural gas. Sinclair explains, "It's struggling . . . because it smells the real teeth of retaliation for sanctions being in the simple acceptance of any currency whatsoever for payment for gas to Europe. Believe me, they will settle in other currencies. . . . It makes energy cheaper. Why in the world would anyone want to pay in dollars if they can pay in their own currency? Russia could retaliate in a way that would have phenomenal impact on the U.S. dollar. . . . Russia has the upper hand. They have it in their ability to turn the U.S. economy upside down and into collapse. There is no question whatsoever. Putin doesn't need a nuclear bomb. He has a nuclear economic bomb that he can set off at any time."
What would the price of gold be this year? Sinclair predicts, "Gold has $2,000 an ounce in its sites in 2014." On silver, Sinclair says, "Silver is gold on steroids. When gold takes off, silver goes up faster. . . . So, the idea you are going to get an old high on silver or better is a given."
The comments were part of a 29-minute interview. The video is worth listening to and Sinclair's comments mirror my own thinking as it relates to the pressure the US dollar has been under since the middle of last year. Sinclair's comments on recent dollar weakness can be heard at about the 13 minute point in the video.
My own thoughts - partially reflected below - are that the dollar is indeed under significant pressure:
. . . . we are now fully engaged in QE taper with the prospects for ending all asset purchases in the next few months. Furthermore, the Fed's forward guidance on interest rate increases suggests that we may well see an increase in rates before the end of 2014. That should be bullish the dollar yet we haven't seen much dollar strength this time around unlike what we saw with just a hint that taper was on the way in early 2013. That suggestion pushed the dollar up from roughly 80.50 to about 85.50. Now that we are fully engaged in QE taper the most the Fed could do was push the dollar from 79.50 to 81.50 before falling back to 79.50 again.
The following chart of the US dollar index illustrates the point Sinclair is making and the point I have been making for some time now:
(chart courtesy of tradingcharts.com)
Another chart that seems to inform us on the matter is the following chart of the spread between Brent and WTI crude courtesy of ycharts.com:
A look at the futures charts of Brent and WTI (chart courtesy of barchart.com) reflect that Brent is up roughly $3 from its January low and WTI is up $10:
Perhaps there are a number of explanations for why this sudden drop in the spread but the one that seems most logical to me is that WTI will continue to be priced in dollars regardless of the geopolitical realigning that is occurring at the present, whereas, Brent - the pricing benchmark for 2/3s of the world's internationally traded crude oil - will move away from the dollar if the US loses its petrodollar strangle hold on world crude sales. The implications for a weaker dollar and the move away from the dollar would imply that WTI will gain significantly as the dollar falls and that is exactly what we are seeing.
Whether the US does lose control of the dollar or not is still up in the air but it would seem money flows amongst the world's crude traders are pricing in that eventuality. Keep in mind, at the present, the world's crude oil trade is still conducted in US dollars so the idea that the two markets are merely reflecting the dollar weakness doesn't explain the spread shift since both should be moving higher at the same rate if the matter were merely one of dollar weakness.
The momentum seems to be working against the US on this matter and from my perspective it is only a matter of time before the world forces the US into a new system of international trade. Clearly the current arrangement is seriously flawed and does allow the US their "exorbitant privilege" and at the expense of everyone else. The question though, from an investors' perspective is twofold - when will this change occur and what will the impact be of a shift away from the US dollar to various investment assets?
What happens when the Fed's money comes home?
We don't have a lot of history to reflect on that informs us on what might occur if the US dollar loses its reserve currency status. Perhaps the closest we can come in this matter was in 1971 when we declared the US would no longer redeem dollars for gold. The long-term US dollar index chart below (courtesy of chartsrus.com) shows that the dollar fell from 120 to 80 - a decline of roughly 1/3 - over the course of the following 10 years:
The dynamics of today's global economy are far different than in 1971 as is the massive levels of direct intervention in the markets by central bankers who seem convinced they can eliminate the cyclical nature of the markets. That said, we can still gain some insight on the matter by looking at the market reactions when the dollar began its precipitous fall in 1971 but first, let's look at another chart courtesy of the Washington Post:
The chart above shows an astonishing surge in foreign holdings of US debt around the globe since the turn of the century. Some wonder why the US has struggled to meet the Fed's 2% inflation target in spite of massive levels of QE money creation. The answer to that question lies in the fact that we have exported our inflation to other countries - at least that is a significant part of the explanation for why the US inflation rates remain tepid.
The following diagram explains how the Fed manages to export inflation. Keep in mind inflation occurs when M2 growth outpaces GDP growth and that is not occurring in a situation where the Fed's newly created money is spent into the domestic economy (which does increase M2) and then exported to foreign countries (decreasing M2).
The flow diagram is very one dimensional and is not fully representative of the nature of money flows in that China is only one of many countries the US trades with. The point is that it doesn't really matter whether US businesses and consumers buy goods from China or another country as the money still leaves the country and is no longer counted as M2 and therefore M2 expansion is not outpacing GDP.
The following chart comparing M2 growth to GDP shows that the M2 growth line is actually a little flatter than the GDP growth line. The takeaway is that we don't have too much money chasing too few goods and, in fact, the inverse is true - therefore no inflation.
The charts and the diagram above need to be taken into account to fully explain why the US - to date - hasn't seen significant inflation. Of course inflation doesn't measure the impact of the Fed's money creation on risk assets such as US stocks and bonds. The truth is that the Fed's money is going into US risk assets and that explains why we don't see high rates of inflation but we do see incredible bull markets in both bonds and stocks.
In other words we do see the impact of inflation from the Fed's actions but not in the CPI - rather we see inflation in risk assets priced in US dollars. That said, we saw a shift in trend in 2013 that pushed foreign holdings of US Treasuries lower. If the US continues to create new debt at the rate of the last 6 years and we find that foreign countries no longer desire our debt due to shifts in the way global trade is settled then we could be close to a seminal moment.
So, back to the market implications. First, let's look at US Treasuries (NYSEARCA:TLT):
(chart courtesy of yahoo)
If China and others are moving away from the dollar then their need to buy US Treasuries is considerably diminished. Furthermore, a continuing weakness in the dollar would add additional incentive to move away from US Treasuries.
So what happens to those dollars that are still flowing around the globe to settle international trade. Remember, the US dollar is still used to settle roughly 80% of global trade. The logical answer is that they move back to the US and into inflation sensitive assets - assets like gold, silver, farm land, ranch land, commercial real estate and residential real estate to name a few.
One could expect a sharp spike in real estate prices as inflation heats up and that would go a long way to reviving the real estate market in the US and solving the problem of underwater mortgages. One could even conclude that the wealth effect would finally be felt by a good percentage of the American public - at least those who are homeowners.
And the pressure to curb inflation as it heats up and the need to support US Treasuries almost certainly suggests we will see higher rates soon. Additionally, the Fed is pulling back their support of the bond market by ending QE and the bond market will lose further support as the trend to move away from the dollar means a dramatic slow down in foreign purchases of US Treasuries. It would seem the only way to support the bond market would be to raise rates and that should bode well - in time - for those who would like to see some income from their bond holdings.
So what about stocks? That one is a little tricky. Some stocks are likely to fare well in this situation and others could get crushed. Certainly mining stocks should fare well in an inflationary environment. As we've already seen - the dollar's weakness should cause crude to continue to climb and that could bode well for portions of the energy sector. The same would apply for real estate and in fact this might be the big winner if inflation were to spike sharply higher.
The big question one must ask - if dollars are no longer used as the means of settling international trade obligations then they are no longer being held as reserves and so where do they go? The answer seems obvious - they come home and they are invested in inflation sensitive assets.
That said, there is some good and bad in this picture. On the bad side, stocks are inflated largely due to massive levels of leveraged carry trades and the shift in currency relationships and interest rates is likely to cause an unwind of those carry trades as the positive metrics of the carry trade turn negative. That means a mass exodus of leveraged positions in stocks.
It seems the stage is set for a huge flow of money back into the United States as there is really no other place for those dollars to go but that doesn't mean into US stocks necessarily. The chart below reflects the period from 1950 through 1980 and shows what happened shortly after the US closed the gold window:
(chart courtesy of yahoo)
What we see is a continuation of the momentum in stocks after we closed the gold window for a little while followed by a sell off of roughly 45% in stocks.
The chart below reflects the S&P 500 overlaid with an inflation chart for the same period as the chart above to show that the initial impact of closing the gold window was a sharp spike in inflation that was followed by a sharp sell off in stocks:
As one can see from the chart above stocks do have an inverse correlation to inflation but only when inflation moves sharply higher or lower. What we see in the chart above is that inflation spiked from roughly 3% to 11% after the gold window was closed as stocks fell by roughly 45% with the S&P 500 lagging the sharp move in inflation by a few months.
Inflation is rarely a factor in stock price and only matters when the rate of inflation makes extreme moves in either direction. For example, in 1980 when inflation fell dramatically as a result of Paul Volcker's decision to push rates sharply higher, the impact of sharply falling inflation was that discretionary income increased and that proved to be a significant driver of stocks after the dust settled. And, when inflation spiked sharply higher after Nixon closed the gold window, the inverse occurred - a contraction in discretionary income in a short window of time eventually pushing stocks sharply lower.
It would seem the possibility exists for a sharp and rapid increase in inflation in the coming months and that is likely to have a very negative impact on stocks in that we could see a further decline in discretionary income. Additionally, one needs to understand the consumer is already stretched and the situation will only worsen as fuel and food prices spike. Couple those factors with the unwinding of massive carry trades and the outlook for stocks - at least the broad indices - looks negative.
This is not a doom and gloom forecast though. In fact, it presents great opportunity for stock pickers who take into account the ongoing shift in the macro landscape and seek out those stocks that should perform well in an inflationary setting. Certainly there will be a lot of money looking for a home as the Treasury bond unwind frees up funds.
The Fed's conundrum
The following chart goes a long way toward explaining how US stocks and bonds have fared so well in spite of the fact that economic growth has been tepid at best. The chart below (courtesy of treasury.gov) compares the current yield curve with the yield curve for the same date in 2007:
Why is this chart significant? The answer is pretty straightforward - one can borrow short term and invest long term and capture the spread. If properly constructed, the carry trade is relatively low risk. So what constitutes a properly constructed carry trade?
One way to construct the trade is to buy US stocks or bonds and hedge price risk. The trade is funded with short-term money and the money is invested in the asset of choice. Let's say one buys a US stock paying a 3% dividend and borrows at the short end of the curve. The gain is just under 3% per year.
The risk is twofold - one, the stock falls in price by more than 3% or the short-term borrow rate moves sharply higher. That said, there are ways to hedge some of that risk. As it relates to price, one could go price neutral by selling in the money calls or buying puts. Another way to offset price risk is to short the futures market. Once the hedge is in place the only limit to the amount of money one can make is the amount of leverage one employs and make no mistake - leverage has been employed at levels that are without precedent.
Still, no trade is without risk and that leaves the greatest risk to the trade being a sharp spike in short-term rates. As one can see from the chart above the present slope of the yield curve is very attractive for a carry trade but the slope of the curve on the same date in 2007 offered no opportunity to borrow short term and invest long term. The point is simple - if we do have a sharp spike in short-term rates then the metrics of the carry trade are no longer profitable and that means those who hold leveraged carry trades must liquidate the trade by selling the stocks or bonds and lifting the hedge.
So are there any clues that we can find that suggest the risks are increasing that the curve is going to flatten? Well, recent price action suggests that we may be seeing an unwind of carry trades as reflected in the chart below:
(chart courtesy of yahoo)
Price action of late has been an overnight ramp in stock futures producing a higher opening - often times sharply higher - while the cash market begins a gradual slide throughout the day after the higher open. The result - a rather flat performance year to date as reflected in the chart above of the S&P 500 (NYSEARCA:SPY), the Dow (NYSEARCA:DIA), the Nasdaq (NASDAQ:QQQ) and the Russell 2000 (NYSEARCA:IWM).
A look at the last 30 days for the S&P 500 reflects that a good number of days - a majority in fact - result in a close that is lower than the open:
(chart courtesy of yahoo)
One explanation for the price action reflected above is that hedged carry trades are being unwound - one leg at a time - with the stock index futures charts moving higher overnight reflecting a possible exit of the hedge side (in other words futures are being bought to close out short side trades) of the carry trade and producing an overnight ramp in the futures and, the cash side of the trade being closed out during the day session pushing stocks lower shortly after the higher open.
So, back to the Fed's conundrum. If the dollar is under attack - and it is - then the Fed has no choice but to take steps to defend the dollar. That explains why the Fed is unwinding the Fed asset purchases, and doing so at a pretty fast clip in spite of the fact that the targets that needed to be reached in order to withdraw stimulus - i.e., inflation and unemployment - have in fact not been reached.
We are also seeing a massive ramp up in the Fed's reverse repo actions. On March 31st, the Fed did a total of $242 billion in one day reverse repos. The Fed explains these operations are part of "an operational readiness exercise." Readiness for what though as they certainly don't offer further clarification leaving us to our own devices to discern the reason.
I can think of a few reasons for why the Fed is engaged in this unprecedented operation:
- They are effectively withdrawing liquidity from the system and sterilizing at least a portion of QE asset purchases as they continue the taper.
- They are now competing with the carry trade crowd for short-term money and in so doing they are firing a shot over the bow warning to those engaged in leveraged carry trades.
- They are preparing the system for that point when the Fed moves to rapidly raise rates in defense of the falling dollar and weak bond market if the need presents itself.
One thing seems certain - there is simply no precedent to the Fed's reverse repo operations - operations that totaled over $5 trillion in the first quarter of 2014.
In any event, the Fed's real conundrum is to simultaneously support the US dollar, and in so doing, protect the positive metrics of the yen carry trade while continuing to provide economic stimulus to the domestic economy. Unfortunately, the two objectives seem - at this point - to be mutually exclusive.
Perhaps I am being just a little cynical here but if memory serves me, the situation the Fed finds themselves in today is exactly that situation Robert Triffin defined back in the 60s - the Triffin dilemma - that explains a reserve currency used for international trade settlements should not be a sovereign currency as there are times when the need to implement policy that addresses the needs of the sovereign's domestic economy produces a destabilizing effect on nations that rely on the currency for international trade.
Both bull and bear markets have always ended at some point and analysts that can shed their confirmation bias that causes them to look for information that supports their bias and, instead, look at the macro picture with objectivity are the ones most likely to identify subtle shifts that will signal the end. What is particularly problematic in that regard is that momentum almost always pushes both bull and bear markets beyond what is rational and makes almost all contrarian forecasters look a little lame in the short term as they attempt to define the factors that will end the prevailing trend.
Furthermore, much of the analytical work necessarily is based on supposition and no matter how logical one presents his premise for how a market trend might end he is basing his forecast on a guess. That said, a good analyst will reject a premise when market action proves that his premise is wrong and look for other information that will better describe why markets are acting in a way that he thinks is irrational.
That is the process I have gone through for a little over a year now and my premise, at the moment, is based on the fact that the market movement is purely a function of the carry trade metrics and nothing more. It seems to fit the facts better than any other explanation I can think of and it is based on the idea that central banks - primarily the Fed and the BOJ - have provided the funding and the yield curve that has allowed an ever increasing push higher in equities as more and more money is provided that allows for increasingly larger carry trade positions.
And, a properly constructed carry trade is not dependent on price risk if that price risk is properly hedged. It is dependent only on the yield curve. For instance if stocks fall 10% and the hedge is in the futures market in short positions in the stock indexes then the trade is price neutral meaning that the trade is still going to make the yield curve spread differential.
I have asked myself over and over why the market won't correct and the answer seems more readily apparent if one recognizes that the price of the stock market doesn't matter to the carry trade crowd in that they are going to add positions - with leverage - on a continuous basis and for the simple reason that the more positions they have on the more money they make and they make that money regardless of price and dependent only on the positive metrics of the carry trade.
Of course the market won't sell off if positions are constantly being added regardless of price and based only on the yield curve as those playing this game continue to put bid pressure on the market as they increase their leveraged trades. It is this dynamic that - in my opinion - best explains why the market continues to stay aloft when traditional analysis suggests it should correct.
You see, those who are adding positions at all time highs are completely indifferent to price as they are not betting on price - rather, they are betting on the central bank's promise to continue with a ZIRP policy and as long as the yield curve stays in place and they have gone price neutral it makes sense as they are assured a profit regardless of where stocks are priced.
So, from my point of view the real risk to the stock market is whether or not the Fed can control rates and keep the yield curve that currently exists in place. Perhaps they can but that seems to be dependent on the idea that those who could create an imbalance elect not to do so. In other words, what do the China/Russia led contingent decide to do next.
Those who suggest that doesn't matter are simply naive as it seems obvious the Fed's reverse repo operations - beginning last year and shortly after the Durban Summit which was followed by China's first round of Treasury sales - are designed to mitigate the effect of these actions.
Furthermore, the Fed's decision to end asset purchases is most logically explained in the same context - in other words the need to defend the dollar against the attacks by the China/Russia led contingent. No other explanation for these dramatic shifts in policy makes sense - at least to me.
If my assessment is correct we will see a continuing weakness in the dollar as more and more dollars find their way back into M2 and that should finally create that inflation the Fed has been striving to achieve. That has both negative and positive consequences. First, the Fed will - at some point - need to allow rates to rise on the short end in order to keep some support under the bond market. Those who prefer fixed rate investments will be the beneficiary of this shift as their money will finally be put to work at reasonable rates - at least if the inflation rate doesn't get too far out of hand.
Additionally, the problem of underwater mortgages should finally be resolved as inflation will push real estate prices higher. And, in fact, GDP should also start to push higher as banks become more willing to lend, but perhaps not until the dust settles a little and assets return to more normal - i.e., not manipulated - levels.
My own thought is that the upcoming G20 meeting could be a seminal moment in that the IMF members have effectively given the US an ultimatum. As a practical matter there is really nothing those member countries that are pushing the US can do in the sense that they can alter the current status quo as they cannot simply push the US aside and proceed on their own. To do so would require that roughly 80% of the member countries agree to a change and that is not likely.
That means the only thing that can be done to make good on the ultimatum is for a large group of countries to simply agree to participating in a parallel system - a system that is already, to some degree - in place. What is needed is a clearing bank and an alternative SWIFT system.
Consider these comments in an article entitled - Russia to create foundation that could one day become an alternative to SWIFT:
The move to eliminate the Petro-Dollar and dollar hegemony is inevitable, as predicted by several well known economists this year alone. And with both Russia and China, along with the occasional assistance from other BRICS nations like India and South Africa, creating similar facilities used in the West like the BRICS bank, gold trade note, and soon, an alternative to SWIFT, the day could be coming very soon where the U.S., like Britain in the 1950's, will be unable to withstand the sea change of nations shifting away from the dollar, and enacting a new monetary reserve system that cannot be used by one nation to impose their will upon others.
My own view is that this is no longer academic and is at the heart of the geopolitical wrangling that is going on at the present. Sometimes it seems that change takes forever and sometimes change comes much faster. Whether the seminal moment occurs at the upcoming G20 meeting or not is a matter of speculation. My own view is that the odds are 50/50 that we do see a break from the IMF and a promise by certain key players to immediately begin the process of implementing a parallel system.
I will leave you to ponder on these comments from a recent ZH article and as you read the comments, ask yourself what you think the logical response to the actions taken by the US via JPM might be:
Wait, did JPM just take a unilateral action, not mandated by the state department (because nowhere in the Russian sanction list does it say putting a freeze on Russian bank transfers), and refuse to process a simple money transfer? Why? And if indeed JPM is doing this, how long until all other US banks, most of which are just as allegedly criminal in dealing with offshore sources of illegal money, follow suit and leave Russia entirely in the world when it comes to USD-backed transactions.
Because what JPM may have just done is launch a preemptive strike which would have the equivalent culmination of a SWIFT blockade of Russia, the same way Iran was neutralized from the Petrodollar and was promptly forced to begin transacting in Rubles, Yuan and, of course, gold in exchange for goods and services either imported or exported.
One wonders: is JPM truly that intent in preserving its "pristine" reputation of not transacting with "evil Russians", that it will gladly light the fuse that takes away Russia's choice whether or not to depart the petrodollar voluntarily, and makes it a compulsory outcome, which incidentally will merely accelerate the formalization of the Eurasian axis of China, Russia and India.
At this point watch if any other US banks follow in JPM's footsteps, and block money transfers to or from Russia. Because then will things get truly interesting.
As for the Russian response, it is coming and will most likely be matched in severity.
Disclosure: I am long GLD, SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.