currency currents

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CURRENCY CURRENTS A free global-macro & market newsletter

Tuesday 11 August 2015

Quotable

“If you are going to use probability to model a financial market, you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising—far greater and moredamaging than the mild variations of orthodox finance.”

Benoit Mandelbrot, The Misbehavior of Markets.

Commentary & Analysis

Oil $10 per barrel—Are you nuts? Not if stocks help the process along…

The news concerning China’s decision to devalue its currency could have broad implications for theglobal economy. The key question is will stocks wake to the reality of the growing disconnect betweenthe financial and real economy—has the valuation rubber-band stretched far enough?

Today’s devaluation comes on the heels of the Chinese being iced out by the International Monetary Fundfor inclusion of its currency—the yuan—into that” all important” basket bundled by the IMF call SpecialDrawing Rights (who even has a clue what that stuff is or used for). So, instead of global reservemanagers having to shift a wole bunch of captial into the yuan, we may witness a whole bunch of portfolio managers shifing a whole bunch of capital out of China. Can you say hot money flow to the USdollar via US Treasuries to hide? 30-year Treasury futures jumped a whopping 2 points today, i.e. long bond yields fell.

Today’s action by the Chinese seems a bit of capitulation on their part to the powerful deflationary forceseating away at them—overcapacity (read malinvestment), tepid global demand and rising debt (with all its juicy feedback loop growth crushing implications) are not what keeps hundreds of millions of Chinese people fully employed. Of course the mere mention of China problems leads to thinking aboutcommodities; and commodity currencies. Given the battering commodities have already seen (theThomson Reuters Commodities index has made a round trip since the central banks started stimulating inan effort to help the real economy), the question is can the major commodities, thinking primarilyindustrial metals and energy, go much lower?

The short answer is yes.



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Weekly .TRJCRB 4/5/1991 - 4/6/2018 (NYC)

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The real economy continues to get whacked realtive to the financial side. Today’s announcement byChina, relatively more dependent on the real economy, is an exclamation point on the massive disconnect between the fiancial and real economy.










Yesterday a friend sent me a private global macro newsletter written by a man who has been doing thisthis stuff for over sixty years at his own investment firm. This advistor said he is expecting it all to end incalamity—and soon.

He believes stocks are close to a supercycle top, evidenced by massive distribution of stock by insiders forthe last few years and his own form of wave analysis applied over a very long timeframe (I do not have permission to share his charts unfortuantely).

For grins, I have taken the cash S&P 500 index monthly chart measured from the 1987 crash low (theend of the world as we knew it at the time; at least for the mortals such as me) and counted up in an A-B-C pattern. Wave C is slightly longer than A, which targeted to 2,056 (I am not pretending any validityhere, just playing with charts; but it gives you a clear indication of just how massive this rally has beensince the central banks got busy after the credit crunch in 2008). Is there any doubt after viewing thischart where most of the money and credit created globally went?

My investment advisor friend thinks oil will visit the $10 per barrel level before this is over (back to themid-1980’s prices); a fresh new low in oil today by the way. Is he nuts?

$10 oil seems extreme, but there is a lot of air between $43 and $10 even though there has already beenmassive damage to the sector since those heydays of Peak Oil worship when black gold hovered near$150 per barrel (all the cheerleaders for Peak Oil promised us that $200 oil was here to stay). If Chinaleaves the building, oil could go a lot lower.










The reason China is so important for oil prices at this juncture is because it doesn’t seem the US“recovery” is quite strong enough to pull the global wagon alone. From Russ Koesterich, global chief

investment strategist at BlackRock, writing in the Financial Times recently:

Even if you optimistically assume some acceleration in borrowing as income growth rises, anolder, more indebted consumer is unlikely to borrow at the same rate as pre-crisis. Assuming the pace of household debt accumulation converges to a level consistent with nominal income growth,this alone would suggest a 1 percentage point reduction in the rate of household spending relativeto the historical average.

The obvious way out of this dilemma is faster income growth. Not surprisingly, income growthhas historically been the single largest driver of changes in consumption. Looking at 20 years ofUS retail sales data, the year-over-year change in personal income explains roughly 50 per cent of

the variation in retail sales growth.

The challenge is that a sustained acceleration in income growth is unlikely without stronger productivity. Unfortunately, the latter is either proving elusive or, at the very least, more difficultto measure in today’s service-driven economy.










Without higher productivity, investors probably need to lower their expectations of what the USconsumer can deliver. To paraphrase Mark Twain, rumours of the rude health of the US consumermay have been somewhat exaggerated.

In short, if the US consumer can’t do it, there isn’t anyone left who can trigger an uptick in globaldemand. And all those cash flows supporting stock prices will likely start to wilt under the pressure offalling top-line growth.

I realize even verbalizing the idea of $10 oil prices means thinking about a massive global deflatonaryscenario—great depression type of stuff. This fear may seems the justifiction for central banks to keep ondoing what they are doing in an effort to keep hope alive.

But if the stock guys get spooked by China the rationale of the massive financial-to-real economydisconnect may become the new investment theme instead of the don’t fight the Fed theme. Of courseChinese concerns have been in the market for a while and it hasn’t seemed a big deal. But today’sdevaluation adds a layer of complexity. Will central banks now backtrack on rate threats? Will emergingmarket currencies get hammered more on the back of Chinese export competition al la a lower currency?If China does export more, is it only stealing demand from other Asian competitors? Will Chineseregulators clampdown on captial flowing out of China? Will the Chinese stock market benefit fromtoday’s action given Chinese stocks look a bit cheaper in yuan terms? Will further official devaluationtrigger trader tarriffs? Will the Japanese yen rise in value on repatriaton flow?

How perfect would it be if Warren Buffet’s biggest acquisition to date—announced yesterday—is the bellringing at the top?

As I have talked about many times before in these pages, the stock market is a massive repository of realeconomy collateral value (on which many $’s worth of lending depends); thus a fall in stocks will have ina direct and immediate negative feedback loop into an already relatively weak real economy. Part of thefinancial bubble game was triggering the positive feedback of the “wealth effect.” That is what central banks were counting on when they became stock market cheerleaders instead of boring central bankers.

I am not arguing all the juice into financial assets hasn’t had some residual benefit for the real economy— it certainly has. But I believe its fair to say the impact hasn’t been as expected given the historicalweakness of the current so-called recovery. It seems to me the balance sheet recession is alive and welland financial repression isn’t the way to set the stage for fresh growth especially given the world lurchedfrom overleveraged—the credit crunch—to even more over leveraged thanks to QE.

The negative feedback loop of falling stocks in a world of extremely tepid global demand might just makethe crazy idea of $10 oil a lot less crazy sounding. Stay tuned.

Three announcements from Black Swan Capital:

1. We have expanded our trade ideas to include currency futures traded on the CME inaddition to spot forex (we provide the side-by-side levels for spot and the nearby currency futuresequivalent).










2. We are starting a new Letter of Direction Program through JH Darbie & Company. It isdesigned to allow JH Darbie & Co. execute the trade ideas offered in our Black Swan Forex (andcurrency futures) service on your behalf.

3. We will be hosting a webinar, likely next week, where we will share our global macro view andits impact on the major currencies in light of the Chinese devaluation, sharing some of our latestideas and our long-term global macro currency trading idea. Stay tune for registration in Currency

Currents this week. [Dan Uslander from Darbie & Co. will be on hand to briefly describe theLetter of Direction Program and answer any questions.]

Regards,

Jack CrooksPresident, Black Swan Capitalwww.blackswantrading.com [email protected] Twitter: @bswancap



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