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China, The Global Carry Trade and Oil

In my first issue for subscribers in June, I interviewed money manager Philip Treick, Managing Partner for Thermopolis Partners out of Jackson Hole, Wyoming.  He has an interesting theory on the how and why of the global economic collapse in 2008, and specifically how investors should prepare themselves for the future. 
His ideas on how the global economy would play out are being realized every day now, as the US dollar slips to new lows.  I am re-publishing the article here because, as the carry trade with the US dollar increases, the potential for another calamity grows greater – and it’s only one year later!  Perhaps it’s true – the only thing we learn from history is that we don’t learn from history.
What really caused the oil price to collapse? Philip Treick says it’s not what everybody believes.
Conventional thinking believes the oil price collapsed because of the dropping global demand from a worldwide recession sparked by the US sub-prime fallout.
Treick, founder and principal of Thermopolis Partners LLC, has a slightly different view. He explains how everything – the oil price collapse, the global economy collapse – started with an unannounced policy change in China towards its currency.
More importantly, he uses his theory to tell investors what to look for in the coming months and years that will guide us in finding profits. His charts, reproduced below, provide a sharp image to back up his comments.
KS: Most people think the collapse in the US subprime housing crisis caused the global recession. But you don’t. Why is that?
Treick: Well, I point out if you look at mortgage equity withdrawn in the United States – that peaked in late 2006. Identifying that point in time as the top of the credit cycle, our credit based economy had already started to contract prior to the collapse in oil and copper. So one can’t say that the credit contraction was the sole cause of this collapse in commodity prices, because it was already in full force. It definitely contributed to it, but it wasn’t the sole cause. Something else had to contribute. That something else was an unannounced change in currency policy out of China….that was the straw that broke the camel’s back.
KS: Tell us how the Chinese currency caused most of the carnage we see in the world now and what that means going forward.
Treick: Well, let’s break that question up into a few parts. If you start at the very beginning, or in this case mid 2005, the Chinese Yuan was pegged to the US dollar. It didn’t float. The Chinese were running huge trade surpluses with the rest of the world, yet their currency remained tied to the dollar and therefore was very cheap.
What was left of the US manufacturing sector had started to complain about this, basically saying that manufacturing advantage that China had was due not only to its cheap labour, but more importantly to its low valued currency. As a bit of background, among the prerequisites to joining the WTO (World Trade Organization), China had committed to work towards opening up its markets and most and floating the Yuan. China had started to open markets to foreign competitors, but up until mid 2005 had refrained from revaluing its currency.
As complaints from the US grew louder, it appeared there was going to be some political backlash against China. So after several political jabs, I think they responded in the end by saying, “Okay, we’ll begin to revalue the Yuan.” At this point, they could have done a one-fell swoop revaluation which would have probably been pretty traumatic for their export industry because it wouldn’t have given Chinese companies a chance to prepare for the new currency regime. So instead, they did a gradual revaluation, and in the process invited all of the hot money in the world to flow towards China, to take advantage of what would be the monster of all carry trades.
KS: Can you quickly explain what a carry trade is?
Treick: You borrow at a low interest rate in one currency and invest at a higher rate in another. What makes a carry trade work is wide differentials between sovereign rates and low volatility between the currencies. By virtue of the fact the Chinese were going to manage this appreciation, it was by definition going to be low volatility. On a chart, the Yuan per US dollar headed down and to the right with little variance. That condition held from August of 2005 all the way to July of 2008.
KS: So what happened when all this was set up?
Treick: Over time, as the Yuan appreciation occurred, there were huge incentives for Chinese companies to borrow in dollars and either invest back in their own market or just hold Yuan– and take the appreciation. The cost to borrow in dollars was more than made up by the rate of appreciation in the Yuan. So it was just a pure carry trade and it grew to be very large. Going into the summer of 2008 the steadily appreciating Yuan had begun to cause problems for the Chinese. Investors and speculators piled into this huge carry trade trying to capitalize on the managed appreciation of the Yuan; however, there was a growing uneasiness amongst many Chinese manufacturers of lower value-added items. Bankruptcies were beginning to climb rapidly. In fact, there were massive bankruptcies in China amongst these companies that were doing low value-added manufacturing like toys and apparel, because of the Yuan appreciation. They couldn’t compete with the Vietnamese or other low-cost countries that had even cheaper labour than they did.
So they started to scream and not unlike the United States, the politicians listened to their constituents. One started to see news items coming out of China on Bloomberg, writing of a growing wave of bankruptcies. Figures in the Chinese Central Bank and others began talking about the need to slow down the revaluation, if not halt it altogether. But for every story about these manufacturers in China that were going bankrupt, there was another story about how China was actually going to strengthen the Yuan even more.
So although it was unclear what would happen, the Chinese Central Bank reversed direction and started pegging the Yuan to the dollar beginning the week of July 17th, 2008.
KS: Before we go any further, can you tell us how this appreciating Yuan affected global oil prices from 2005-2008?
Treick: Yes, first off, all commodities are quoted in dollars. One never hears oil quoted in Euros for example. Since the dollar is the measuring stick for price in commodities, then fluctuations in its value (the dollar) versus other currencies have an effect on commodity prices. During the period of 2005 through the summer of 2008, the dollar fell broadly against our major trading partner’s currencies. So not only was the dollar falling relative to the Yuan, but it was falling relative to the Euro and Brazilian Real as well.
This resulted in a virtuous circle of sorts. As the dollar depreciated overall, the Chinese revalued more aggressively which is why the Yuan / Dollar graph steepens in descent. This only added to the carry trade economics as it became an excepted fact that the dollar would continue to weaken.
On top of this, the concept of peak oil began to gather momentum. Combining a weak dollar with potential pending supply problems figuratively lit a fire under oil. It appeared we could easily print dollars to buy hard to find oil. Hank Paulson, the US Secretary-Treasurer at the time kept saying that the global growth was strong, and the economy would be all right. But it wasn’t going to be all right because starting the 3rd week of July in 2008, the carry trade started to unwind unleashing a myriad of unintended consequences.
It first and foremost caused a short squeeze in the dollar and yen, which led to credit spreads blowing out and the near bankruptcy of the entire leveraged financial system. The second unintended consequence of the policy change was the collapse in commodity prices attributable to the spike in the value of the dollar. Therefore, the combination of the blow out in credit spreads with the collapse in commodity prices caused emerging market economies to implode.
The global growth scenario Paulson had previously been crowing about seemingly reversed on a dime.
KS: OK, I understand the argument. Two questions come to mind. One, why hasn’t this angle been picked up by anybody else, and two, if this is true, is there any way we investors can use this theory to position ourselves in the markets moving forward.
Treick: Most of the world missed this story – there was never an official policy announcement. Clarium Capital wrote about it, but it remained under radar as far as we can tell. Certainly a lot of people were focused on what the Yuan-dollar relationship was. But by the time the line was flat long enough to be a trend, it was too late. What appeared to be small corrections in oil and copper became something much bigger. In reality, the brute force mechanics of a carry trade are, that if you borrow in a weak currency to fund investments predicated on the currency getting cheaper…and overnight the currency turns strong…depending upon the leverage used, the trade can eat you alive.
It is obvious now that a tremendous amount of leverage was employed, so as soon as the dollar and the yen turned directions, it really caught people off guard and they had to scramble. As they scrambled they made it worse.
KS: So what does that mean going forward for investors? If all this is true, and we start investing from this idea, how do we make money?
Treick: Now the question you have to ask is, was this just a temporary event, kind of like a bull market correction, so to speak, in commodity prices? Or was it actually the end of the commodity cycle? Our conclusion is that it was more than just a bull market correction in commodity prices. Economies around the world, especially in the emerging markets that sell commodities, were damaged. But you know, it’s only been two quarters and they seem to be starting to recover. We have been investing on the premise that tangible asset valuations are on a secular uptrend.
The argument to that is that commodity price collapsed as a function of the commodity cycle, ie, nothing cures high prices like high prices. But oil production didn’t respond to high prices, nor did many other commodities like gold or even uranium. So I think we’re going to be proven right – that this was more of a currency change and subsequent dislocation and not necessarily a cyclical collapse kind of thing. At least that’s how we’re looking at it. Hard assets and stuff you can’t print– make up out of thin air – are trying to find a way higher.
KS: What does that mean?
Treick: Economies will recover based on stimulus and it’ll be some type of inflationary recovery. When that does happen, the market and companies will be caught flatfooted once again because so many projects that were intended to offset demand for commodities in the future will have been shelved. And so we’ll go back to the scramble for capacity. That’s how we’re positioning for it. For investors it means that resource companies should do well going forward
KS: Any idea on the timing of this? Or what we should be looking for?
Treick: Well, you’re seeing it already. The Chinese are taking advantage of these low commodity prices and they are building their stockpiles of these important tangible assets. They’re looking inward because they’re going to spend a lot on infrastructure and they’re going to spend a lot on stimulus to make sure that they can continue to grow their economy to employ all those people. And instead of trying to sell low value-added items to the U.S. consumer, my guess is they’re going to try to build stuff that they need within their country and then try to sell higher value-added items to the world and the U.S.
They’re out there acquiring tangible asset stockpiles at good prices, right now. In the US it will likely take a generation of people before we want to spend and borrow money like we did leading up to 2008. The demand for credit and the demand for that type of consumption is probably gone for a long time. But that doesn’t mean that that it won’t occur in India, won’t occur in China, won’t occur in Brazil and even Russia and other places like that. They will probably be the drivers in terms of consumption.
In terms of timing, our belief is that commodity prices have seen the lows. Quantitative easing is now standard operating procedure. Using easy to print dollars to buy hard to find oil (or gold for that matter) put a floor under hard assets. This doesn’t mean a buy and hold strategy will work in commodity based companies, what it does mean is that one should buy on weakness companies with strong balance sheets, valuable reserves managed by experienced operators.
KS: What advice would you give for retail investors looking warily at buying commodity stocks again?
Treick: The Chinese will eventually allow the Yuan to break the peg to the dollar. This would put renewed downward pressure on the U.S. dollar, and be positive for resource assets. So in terms of timing, it’s our guess that as long as China maintains the majority of its reserve assets in dollar denominated instruments the incentive to change remains low. Global economies however, have begun to show signs of stabilization. When stabilization turns into growth, it is highly likely pressure will build for China to again revalue the yuan upwards.
When we are convinced that is about to happen, or is happening, we are going all in. So I would tell investors that this last year was as much a currency policy change as it was a collapse in credit. Companies with great resource assets and relatively little debt are still around. We have been focused on resource plays that pay big dividend yields. Could we have corrections? We hope so, because this is not the secular end for commodities, corrections should be bought.
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