Jul 22/15 – The world is starved for US dollars

2015-07-22 11am EDT  |  #China #commodities #Fed #John Connally #US dollar #Yuan

The commodity rout continues unabated. Every tiny rally has been just another chance to get short. The selling has been relentless and unwavering.

Have a look at the CRB Industrial Commodity index:

We are drifting downward in what appears to be a bottomless spiral.

This collapse is crushing the economies that rely on selling these commodities. The Brazilian Real has been decimated over the past couple of years:

Although not wholly a commodity story, the Mexican Peso has plunged to all time lows against the US dollar:

I could trot out a bunch of similar looking charts. Whether it is the Canadian dollar, the Australian dollar, the New Zealand Kiwi or the South African Rand – if your country relies on selling commodities, your currency is collapsing.

And for good reason. Commodities have gone no bid. The decline just won’t stop. Commodity traders are getting taps on their shoulders from their risk managers. Puke points are being hit all over the place. Garbage cans on trading floors are overflowing.

It is feeling an awful lot like 2008, just instead of banks and financials collapsing, it is commodities and the corresponding equities and currencies. During the 2008 credit crisis the selling just wouldn’t stop. Every respite was just another chance to load up on the short side. Even when prices hit the “stupid point” where fundamentals should have stopped the decline, the leveraged players kept selling, overwhelming any value buyers. That is happening today in the commodity square. We are in the final washout where prices of commodities fall below the cost of production causing panic selling and bankruptcies.

Whether it is oil, gold, or even grains, commodities are trading at levels where producers are losing money. This is not sustainable over the long run. Either we will get a monster commodity rally as either global growth (or inflation) picks up, or there will be such a rash of bankruptcies that supply is severely curtailed. But make no mistake about it – we are at the point where declines are only buying opportunities (and not chances to sell more). Prices are below long run sustainable levels. It is similar to 2008 when you were picking up world class banking institutions below book value and knew that if you could hang tough, the trade would work. The key is being able to hang on through this difficult emotional final leg.

It’s all about the US dollar

Why is this happening? Why is there so much pain? Although there are many reasons (including the simplest that previous high prices brought about too much supply like every commodity cycle), the unique situation of the US dollar reserve currency status and the soft peg of the Chinese Yuan is the main culprit.

The Federal Reserve is determined to prepare the market for an upcoming rate rise. Regardless of the fact that inflation refuses to cooperate and rise to their targeted level, the Federal Reserve continues to set the market up for higher rates. Whether you believe the Fed will follow through or not is another question, but there can be no denying they are trying to convince the market rates will be raised off the zero mark. The Federal Reserve has also stopped expanding their balance sheet. They have even experimented with withdrawing liquidity through reverse repos and issuing term deposits. All of these measures are shrinking the amount of US dollars in circulation (or at the very least slowing down the rate of expansion). If you reduce the supply of something, the price goes up. Currencies aren’t always quite so simple as there are also portfolio flows which can affect the demand either positively or negatively. And there is no doubt demand for US dollars has increased because of the perceived notion their economy is less affected by the global slowdown.

I believe the main reason for the US dollar rally is not demand driven, but instead the result of supply being choked off. The US dollar is the world’s reserve currency, and the global financial system requires an ever increasing supply to ensure growth. When this supply is limited, there are suddenly less dollars and the result is deflation. Stop and think back to all the worries from the inflationistas about too many dollars being printed when Bernanke stepped on the QE gas pedal – they predicted a collapsing US dollar with rocketing inflation. Now think about this problem in reverse – a soaring US dollar with relentless disinflation – which is what we are currently experiencing.

The real problem lies in the fact the US economy does not necessarily sync with the global economy. Coming out of the 2008 credit crisis the Federal Reserve was uncomfortably aggressive in their monetary expansion. It caused all sorts of problems with other nations who found their currency exploding higher. Countries like Brazil even accused the US of engaging in a currency war. The world economy did not need the liquidity the Federal Reserve pumped into the global financial system. Maybe the American economy needed it, but the rest of the world certainly didn’t. Due to the fact the US dollar is the world’s reserve currency, this liquidity caused other economies to overheat.

As the Federal Reserve gradually slowed down the rate of expansion of their balance sheet, the global economy also slowed down. The world’s financial system started to be slowly starved of oxygen. At first it was welcomed as there was too much floating around, but the equilibrium point was quickly passed. Before we knew it, the rest of the world was gasping for breath as more and more US dollars were withdrawn from the supply.

Herein lies the problem. The Federal Reserve does not tune monetary policy for the global financial system. Eventually the state of the world economy affects the US economy, and so at extremes the Federal Reserve will respond to global slowdowns with more liquidity. But the month to month setting of monetary policy is largely immune to global developments. That wouldn’t be a big deal if the world didn’t trade most goods in US dollars, or if there wasn’t a huge amount of US dollar denominated debt. But being the reserve currency carries a responsibility that American officials largely ignore.

I guess it is the American’s prerogative to ignore this reserve currency responsibility, but we should just be aware that someday the world might abandon the US dollar as the universal currency. If the US officials refuse to acknowledge the effect their policy has on the world economy, they might some day be in for a surprise when the rest of the world finds an alternative.

Recently IMF head Christine Lagarde begged the Federal Reserve to put off any rate hikes until 2016. She understands the effect the liquidity withdrawal is having on the world’s economy. Her request is an admission of the unique status the US dollar has on world liquidity. The only question is whether the Fed will listen…

And it is only made worse…

I almost think the global financial system could handle the strong US dollar if all the other currencies floated freely. Unfortunately the world’s second largest economy has a soft peg to the US dollar. The Chinese have chosen to tie the value of the Yuan to the US dollar. In doing so, they have effectively tightened monetary conditions along with the Americans during this latest episode. The Chinese are trying to offset that currency strength with easing of interest rates, but there is simply no way the decline in borrowing cost can offset the dramatic increase in the value of the Yuan.

Have a look at the trade weighted Chinese currency chart:

How do you think the Chinese export dominated economy is going to perform when their effective real exchange rate rises by 40% in a couple of years? It is no wonder the Chinese economy is gasping for breath.

The Chinese are desperately trying to hold on to their peg long enough for them to be admitted into the IMF SPR basket. I don’t know the politics of the whole affair, but the Chinese do not want to loosen the band against the American dollar right before the decision. So they are in effect joined at the hip to the strong US dollar.

This is crushing the Chinese economy. My suspicion is the true extent of the economic decline is worse than even the warnings of the most ardent China skeptics. I firmly believe in this day and age of anemic global growth with extreme levels of debt, any currency strength causes a self reinforcing debt liquidation cycle. The entire world is suffering from a ‘balance sheet recession’ and the countries who leave policy the tightest, either through rates or currency strength, quickly import the world’s deflation.

This is the reason we are experiencing a global collapse in demand for commodities. The two largest economies are tightening policy. It is more complicated than that, but at its heart, this is the cause for the recent declines. Eventually this pain will cause dramatic changes. I don’t know how it will play out. It might be the American economy rolls over, joining the rest of the world in economic softness, and the Fed goes back to providing liquidity. Or it might be the Chinese cry uncle and abandon the Yuan/US dollar peg in some sort of game changing monetary policy reshaping.

The global economy is far from healthy. It might be that everything appears fine for the American economy, but if these policies continue, it won’t be long until the world slips into a recession. Raising rates or a strong US dollar doesn’t hurt Facebook or Google, but for the rest of the world, this liquidity withdrawal is deadly.

Thanks for reading,

Kevin Muir

the MacroTourist