What a long strange road it’s been…
2016-01-22 12pm EDT | #China #James Rickards #Saudi Arabia #US dollar
Although most of the recent media attention about US dollar pegs under attack has centered around the Chinese Yuan, there is another pegged currency that is probably at least as important, but not getting much attention.
The Saudi Arabian Riyal has been pegged to the US dollar since 1986. I would post a chart, but it is basically looks like the pulse of a dead man for the past three decades. The peg has been steady and unwavering during this period.
Yet maintaining the peg has not always been easy. One of the best ways to measure the stresses on the peg is to graph the Riyal 12 month forward rate. Due to the fact the Riyal spot is pegged, you cannot easily short the currency. Therefore the easiest way to get short is to sell a forward contract. In doing so, the problem borrowing Riyals is eliminated, and you can simply cover your delivery in the spot market at expiry. When there are large transactions in the forward market, the premium or discount to the spot widens or narrows. This premium or discount is measured in “points.” In the case of the Saudi Riyal the 12 month forward is currently trading at 925 points. That means where the spot is trading at approximately 3.75, the forward rate is closer to 3.84. Speculators are in effect short selling Riyals at a 2.5% discount to spot. That might not seem like much, but for a peg that has held for the past few decades, it is actually quite wide. Have a look at the chart of the 12 month points premium for forward Riyal since the turn of the millennium:
The amount of stress on the peg during the last few months is obvious. And just like China, this has resulted in a large decline in their foreign exchange reserves:
The Saudi Arabian story is similar to China’s. The peg was great when the US dollar was printing lots of money. Liquidity was getting passed around like a doob at a Grateful Dead concert, making the countries with US dollar pegs get extra tokes as their currencies weren’t rising versus all those other free floating knobs. The trouble is that like many things that happen when you smoke strange stuff at a Dead concert, many of those investment decisions would be better off forgotten. The weak US dollar fueled a massive commodity rally, with oil being one of the biggest beneficiaries. Thinking the money would flow forever, the Saudis were especially irresponsible. They paved over way too many problems with promiscuous social spending. That was fine when oil was $100, but now with it trading at $30, the incredible level of spending will result in an astronomical increase in Saudi debt:
The projected fiscal deficit is mind numbing.
And here is the other big problem. The Sunni Shiite conflict is getting worse… A lot worse. All of a sudden Saudi Arabia is fighting a war on its own, and contemplating the possibility of having to fight more in the future. Have a look at their defense spending:
To top it all off, the Saudi royal family is no longer a solid stabilizing force, but instead filled with uncertainty and youthful aggressiveness as the accession to the throne is up in the air.
Although I am a big oil bull, I do not pretend it will rally enough to get Saudi Arabia out of their problems. Just like China, Saudi Arabia cannot afford to remain anchored to the ever rising US dollar.
But what to do about it? Although this situation has been on my radar for the past month, I must admit that a good buddy’s link to a James Rickards webinar earlier this week brought it to the front of my thinking. I had to laugh a little bit about Rickards’ spiel. He was trying to sell subscriptions to his newsletter service, and it felt a little bit like he was peddling his idea on late night TV.
He teased the idea, and then told you about how for the low cost of $1,750 you could get the symbol for the security designed to profit from this coming devaluation. It was some listed security in Turkey or some other ridiculous second derivative idea.
I don’t know how to profit directly from this trade. I can’t trade 12 month SAR forward contracts, and even if I could, I am not sure I would want to pay up right now.
I just wanted to sketch out the idea, but more importantly, leave you with this thought: when the foreign exchange reserves were flowing in, some of those assets were kept in liquid easily tradeable government bonds. But the last half dozen of years has seen a steady move out the risk curve not just by investors, but also by governments. Tracking these assets is extraordinarily difficult. Who knows where the assets lie? On the Central Bank’s balance sheet? Or maybe in Sovereign Wealth Funds (SWF)? It doesn’t really matter, the key is realizing all these reserves that were created with the artificial pegging when the US dollar was low made their way into risk assets. This was part of the monster move higher in high yield debt, equities and other risk assets during 2009 to 2014. Now that this cycle has reversed, these assets will need to be sold.
I have always cautioned that monetizing your debt with foreign equities is an insane policy. However as it was happening and the self fulfilling feedback loop was in full swing, these warnings seemed like the goody two shoes at the Grateful Dead concert who is “fine enjoying the music without artificial adjustments.” But the high always eventually wears off. And the selling is going to be just as painful as the buying was pleasurable.
The longer these countries with artificially high currency levels try to hold out and maintain the peg, the more selling of US assets they will be forced to do. A lot of market commentators are confused by the terrible start of the New Year. They try to reason it out by arguing the US economy is not that bad, so there is no need to sell.
The sellers are not investors thoughtfully examining the prospects for the US economy. The sellers are Central Banks and other SWFs that were liquidating to defend their currency… That is why this environment is experiencing all sorts of “never before’s.” Never before have we had so much risk assets in the hands of government entities.
Lord help us, but I don’t think this trip is going to end that easily… What a long strange road it’s been…
Thanks for reading,
Have a great weekend,