Trying to pick a profitable trade in the foreign exchange market is similar
to judging a "reverse beauty" contest, that is to say, the winner is the least
ugly currency at any given moment in time. All paper currencies are ugly, because
central bankers print vast quantities of fiat currency, to varying degrees,
at the behest of the ruling political elite that appointed them to run the
printing presses. "By this means, government may secretly and unobserved, confiscate
the wealth of the people, and not one man in a million will detect the theft," -
the late British economist John Maynard Keynes, used to say.
In the arcane world of foreign exchange, the axiom, - "the trend is your friend," -
is a reliable piece of advice, since trends in currency pairs can extend for
many months, or even years, and often lead to double-digit returns. As such,
the US-Dollar Index, which measures the US$'s value against a basket of six
major currencies, has suddenly risen +5% higher over the past nine weeks, to
above the 84-level, marking its longest streak of weekly gains in 17-years.
Many traders are beginning to wager that the US$'s recent bout of volatility
is harbinger of a longer term rally that can extend into 2015.
If the US$ index can manage to break through key horizontal resistance at
the 84.50-level in the days or weeks ahead, it would signal a technical breakout
to higher ground. Already, the US$ has rolled up its biggest gains against
Japan's yen, climbing +40% higher from above its all-time lows around ¥76,
to a six year high above ¥107 last week. The other currencies in the pack,
the Euro, British pound, Australian dollar, Swedish krona, and Swiss franc
are also looking uglier these days, but are still hanging around within their
trading ranges of the past 2-years.
Many analysts and traders were caught off guard by the US$'s recent bout of
strength, and as George Orwell used to say; "To see what is in front of one's
nose requires a constant struggle." The most obvious explanation for the US$'s
resiliency is the Federal Reserve's gradual withdrawal from its Quantitative
Easing (QE) scheme. Last year, the Fed pumped $1-trillion of excess US$ liquidity
into the money markets, through its QE-3 scheme. However, at its Dec '13 meeting,
- the Fed switched gears, saying it would gradually reduce its injection of
monetary heroin to the QE addicted markets. The Fed has reduced its QE-injections
by $10-billion /month at each scheduled board meeting this year, to a pace
of $25-billion in Sept '14. The Fed is now entering the homestretch of "Tapering" QE,
and will turn-off the money spigot at the end of October, and thereby removing
a major headwind for the US$.
Economists are now trying to pinpoint when the Fed would begin to hike the
federal funds rate from its current range of zero to 0.25%. Expectations of
a series of baby-step Fed rate hikes to begin sometime in 2015, were heightened
on Sept 11th, with the appointment of the Fed's #2 chief, Stanley Fischer to
oversee the central bank's all-important "financial stability panel" - otherwise
known as the "Plunge Protection Team" (PPT). Fischer's crisis management skills
will be utilized in guiding the clandestine activities of the PPT - as it tries
to cushion the US T-bond and stock markets from the fallout of the Fed's exit
from QE-3. A series of baby-step rate hikes to 1% could tip the US-economy
back into a recession, or worse yet, trigger a -10% correction in the US-stock
market.
Even if the Fed gets cold feet and decides to delay the series of baby-step
rate hikes, the US$ could still win the reverse beauty contest, because the
Bank of Japan (BoJ) and the European Central Bank (ECB) are also expected to
keep their lending rates locked near zero percent for years to come. Better
yet for the US$, - the BoJ is on a set course to weaken the yen by injecting
around ¥5-trillion per month into the Tokyo money markets, through the
end of March '15, and the ECB is preparing to print anywhere from €500-billion
to €1-trillion over the next few years, under its "Targeted" QE scheme,
which is designed to boost bank lending in the Euro zone economy. Thus, the
US$ has the winning edge in the arena of competitive currency devaluations
with its trading partners.
The Emergence of the US Petro-dollar, - Yet there's another less cited
reason behind the recent strength of the US$ index and what could auger the
beginning of a multi-year advance for the greenback, - the US's output of crude
oil and natural gas continues to surge to new record highs. The US's production
of crude oil has reversed years of decline thanks to the development of shale
resources, which have boosted output by +65% over the past six years. The US's
shale boom has allowed producers to unlock thousands of barrels of reserves,
putting the US on course to become the largest producer of oil globally, which
would dramatically reduce its dependence on imports.
US oil output averaged 8.6-million bpd in August, the highest level since
July 1986. "US-crude oil production will approach 10-million barrels a day
(bpd) in late 2015, and will help cut US imports of fuel next year to just
21% of domestic demand, the lowest level since 1968," the EIA says. In Q'1
of 2014, the US passed Saudi Arabia to become the world's largest producer
of petroleum liquids, with daily output exceeding 11-million bpd, including
crude oil, hydrocarbon gas liquids, and biofuels. In fact, the US would account
for 91% of the 1.3-million bpd increase in global oil output next year.
The shale revolution has enabled the US to reduce its imports of crude oil
to 7.2-million bpd, or roughly -34% less from its peak in June 2005. Over the
past decade, the US has reduced its imports of crude oil from Saudi Arabia,
Mexico, and Venezuela, by a combined 2.9-milln bpd, while increasing imports
from Canada to 2.6-million bpd. With OPEC as a whole, the US's oil import bill
has dropped dramatically, to $5.5-billion per month, on average, compared with
its peak outlay of $24-billion in July 2008.
Until recently, the Saudi oil kingdom was able to maintain a steady flow of
1.3-million bpd to the US, even as total US oil imports fell by a third. However,
Saudi Arabia is now losing market share as the shale boom leaves US-refiners
with ample supplies of inexpensive domestic oil. Saudi exports of Arab light
have fallen by 452,000 bpd since April to 878,000-bpd in August, the least
since 2009.
Since hitting a record of almost 21-million bpd in 2005, US-oil demand fell
to 18.5-million bpd in 2013, - the EIA says. Fuel efficiency continues to slice
away at demand, and an aging population is expected to drive less in the long
run. Gasoline demand had been steadily declining since 2007 as motorists drove
less and car fuel efficiency improved.New US vehicles available in showrooms
are +20% more fuel-efficient on average, than vehicles introduced five years
ago, according to AutoNation.
The US's shale oil revolution has helped to narrow the overall US trade deficit
to -$42-billion per month, on average. That's far less than the average deficit
of -$62-billion /month from 2005 thru mid-2008, when the US trade balance was
at its worst. The narrowing of the US trade deficit is adding an estimated
+0.6% to the US's annual economic growth rate, compared with a few years ago.
And looking towards the future, with the growth in world energy demand expected
to increase around +35% by 2030, the US-economy could find itself at close
to self-sufficiency in energy.
The story line for the US Petro dollar is bound to get better in the years
ahead.The US has more recoverable natural gas than any other country. This
represents a century's worth of output and can support peak production at more
than twice the 2013 level. As such, the EIA forecasts natural gas prices will
average below $5 through 2023 and less than $6 until 2030.
A Renaissance in the factory sector - The US-economy isthe lowest-cost
producer of natural gas, and thus, making products such as chemicals, fertilizer,
aluminum, steel and glass are more profitable in the US, and will attract manufacturers
from around the world, (or to Mexico's side of the US-border). This creates
a stronger base of economic growth than the rest of the industrialized world.
Economists estimate that increases in US- oil and natural gas production will
create as many as 3.6-million new US-jobs by 2020 and increase economic output
by +2% to +3.3-percent.
Unlike crude oil, natural gas cannot be easily transported overseas. German
and French companies pay almost three times as much for liquid natural gas,
and Japanese importers pay even more. Currently, US natural gas is priced at
$3.85 per million British thermal units (mmBtu), while Asian importers pay
almost $14 per mmBtu for LNG imports. Europe, which relies on pipeline imports
from Russia, Norway and North Africa, is priced in between at around $11 per
mmBtu. Benchmark UK spot gas prices traded in London are around $8 per million
Btu, while Russian pipeline supplies, which are linked to the price of North
Sea Brent crude oil, are around $12/mmBtu.
Europe's dwindling supplies of natural gas are increasing its import dependency
and its exposure to a global liquefied natural gas (LNG) market where prices
are high because of demand in Asia and Latin America. The cheapest pending
new major gas source will be the US, which could begin exports of LNG, in 2015.
But even this gas, once fees and shipping costs are added, would arrive in
Europe at current spot prices of around $9-10 per mmBtu. New supplies expected
from Australia, the East Mediterranean and East Africa will also be priced
well above $10 per mmBtu.
Aussie dollar Plunges alongside Meltdown of Iron ore market, - While
the US-dollar is enjoying a renaissance as a "Petro" currency, - the Australian
dollar finds itself on the slippery slope of a Bear market. For the week ended
Sept 11th, the Aussie dollar fell -3.5%, skidding to the psychological 90-US-cent
level. The price of iron ore, used to make steel, - and by far Australia's
most important export, - tumbled to five-year lows on Sept 11th, - settling
around $82 per ton, and less than half its all-time high of $185 /ton. The
Aussie dollar's fortunes are influenced by gyrations in the world's most heavily
shipped mineral, which accounts for more than $1 in every $5 of Australia's
export income.
While demand from China's steel mills continued to climb to record highs,
Australia's miners pumped billions of dollars into expanding the size of their
iron ore mines and increased their export capacity, in order to capitalize
on China's high-speed urbanization. Demand for coking coal, which is used to
fire the steel mills, and thermal coal used to generate electricity also played
to Australia's advantage as a large-scale coal exporter. Like all booms however,
Australia's mining bonanza has reached its zenith. China's factory sector sputtered
in August as its industrial output slowed to +6.9% in August, year -over-year,
from +9% in July, - and the weakest since Dec '08. Housing sales in China have
fallen -11% in the first eight months of 2014 leaving developers burdened with
bulging inventories, and fickle buyers. As such, demand for Australia's minerals
could weaken in the months ahead.
Softening iron ore prices, combined with the Fed's tapering of QE-3, have
weighed heavily on the Aussie dollar - the world's fifth most actively traded
currency. Ironically, it's been Australia's mining giants, - Rio Tinto <RIO.N> and
BHP Billiton <BHP.N> that are contributing the most to the supply-side
pressure that is bearing down on the price of iron ore. They are the lowest-cost
iron ore miners (break-even at $45 /ton) and are flooding the market, in order
to push higher-cost miners out of business. With its spending reined in, RIO
has lifted annual production at its mines from 240-million tons to 290-million
tons in a year. It is aiming at 360-million tons, and a supply-side squeeze
is under way.
If the price of iron ore falls below $80 /ton for "an extended period," higher-cost
miners, could close down quickly. Rio, BHP and Brazil's Vale are cash positive
even if the iron ore price falls to $50 /ton. It is why they are boosting production.
According to RIO, about 85-million tons of iron ore production has already
been shut down in China, - where the average cost of iron-ore production is
around $120 /ton. China used to source 50% of its iron ore domestically. Now
it sources 20% domestically: it's not hard to guess which miners are filling
the gap. Smaller miners in Australia are on the edge at $80 /ton, if their
lower-grade ore sells for less than the high-grade ore that Rio and BHP dig
up.
The RBA is banking on a tighter Fed policy to weaken the Aussie dollar over
the longer term, perhaps into the 85-cents to 90-cent range. In the meantime,
Aussie$ traders will track the wild gyrations in iron ore, coking coal, copper,
gold export prices. In the wild and whacky world of commodity trading, sentiment
can often turn on a dime. For example, on Sept 15th, the spot price of iron
ore suddenly jumped +4% higher to $85.20, /ton, and helped to brake the Aussie's
fall at 90-cents.
ECB knocks the Euro below psychological $1.300, While the US$ appears
to be benefiting, either directly or indirectly, from its evolving status as
a "Petro" currency, and psychology behind the Australian dollar has long focused
on its status as a "Commodity" currency, it would be short sighted to omit
that the vast majority of foreign currency transactions are earmarked for buying
and selling bonds and stocks listed in the world's capital markets. Nowadays,
the movement of capital across borders happens with the click of a mouse, from
a legion of traders ranging from such diverse groups, such as of lower-tier
banks, carry traders, pension funds and mutual funds, hedge funds, central
banks, sovereign wealth funds, and high-frequency traders, to the private retail
investor.
In the foreign-exchange market, roughly $5.6-trillion changes hands each trading
day, between the spot, forward, and derivatives markets. The Euro is used in
33% of these transactions, or about $1.85-trillion per day. However, the use
of the Euro in the settlement of commercial transactions is just a fraction
of the overall amount of trading in the common currency, compared to what's
earmarked for investment in financial markets, or what's utilized by speculators,
such as carry traders.
As such, the Euro's exchange rate has been mostly influenced by the actions
of the major central banks. For example, the Euro was climbing higher in an
erratic fashion from the $1.300 area to as high as $1.400 during the 15-months
ending in May '14. The Euro was deemed to be the least ugly currency because
the Fed was injecting $85-billion per month of freshly printed greenbacks into
the US-money markets, and the BoJ was simultaneously injecting ¥7-trillion
per month into the Tokyo money markets, under the respective QE schemes. Although
the ECB was lowering its repo rate to undermine the Euro's advance, the central
bank was still resisting the nuclear option of QE.
However, that perception began to change, when in late August, ECB chief Mario
Draghi suggested the ECB would start to unleash "Targeted" QE - aimed at the
asset backed markets, rather than the sovereign bond markets, but with the
same net results, - a massive increase in the supply of Euros. In a battered
regional economy further shaken by a mini trade war with Russia, the Euro began
to tumble more steeply towards $1.300, and surrendered its gains of the previous
year, as the yield on France's 2-year government notes turned negative to as
low as minus -3-basis points (bps). Yields on Germany's 2-year schatz fell
to minus -7-bps, and have been below zero percent since August 25th.
In this upside-down world, lenders pay borrowers to take their money. It's
a result of the ECB's move to impose a penalty of -20-bps on banks that park
money in the central bank's vaults. The radical move is an attempt to force
banks to lend excess Euros on hand, to businesses and consumers, and end a
long drought of credit in crisis countries like Greece, Italy and Portugal.
However, in many cases, commercial banks, would rather lend Euros to Paris
or Berlin at zero percent or less.
The ECB says it will provide as much as €1-trillion of cheap 0.15% loans
to banks, on the condition that they lend the money to businesses or to individuals,
- "Targeted" QE. The ECB will begin dispensing that money on Sept 18th. These
loans would be bundled together into packages called "asset backed securities'
(ABS's), and the ECB has offered to buy the ABS's with freshly printed Euros.
It's a more intelligent way of trying to jump start an economy, rather than
the QE policies in England, Japan, and the US, which are mainly designed to
inflate the wealth of shareholders in the local stock markets. And targeted
QE increases the supply of Euros floating in the banking system, which has
the side effect of weakening the Euro's exchange rate, in order to help boost
the fortunes of exporters.
SNB says ready to act in wake of ECB easing, While the Bank of Japan,
the Bank of England, and the Fed have resorted to purchasing Treasury notes,
as the key mechanism of increasing liquidity in the banking system, the Swiss
National Bank (SNB) has taken a different route, but producing the same results.
The SNB is limited from purchasing government bonds, because the local bond
market is illiquid - at just $90-billion worth. The SNB could quickly end up
owning the entire Swiss government bond market if it tried to match the ECB's
printing spree. Instead, the SNB has relied upon foreign currency intervention,
- printing Swiss francs in order to purchase foreign currency. Thus, the size
of the SNB's FX stash is the barometer of the scope of the central bank's liquidity
injection operations.
Since Jan '09, the SNB's stash of foreign currencies has mushroomed by roughly
400-billion francs, or a 10-fold increase. The SNB has enforced a floor under
the Euro at 1.20- Swiss franc since Sept '11, through a combination of verbal
jawboning and outright intervention in the FX market. The SNB hasn't been forced
to intervene in the foreign currency markets for the past 2-years, as traders
have shown the utmost of respect for the resolve of the SNB in defending the
Euro's floor at 1.20-francs. However, the Euro has been weakening against the
franc in recent weeks, to as low as 1.205- francs. SNB chief Thomas Jordan
has dropped broad hints that the bank is ready to push short-term Swiss deposit
rates deeper into negative territory to make the currency less attractive.
Given the sizeable amount of bank deposits held with the SNB, such a policy
step could have a particularly strong impact. Negative deposit rates would
make it expensive to hold Swiss francs. As a result, the US$ is looking less
ugly than the Swiss franc these days, whose fate is largely tied to that of
the Euro.
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