Weekly Economic Update 09-15-201

China, Gold, Oil and the End of the Petrodollar

Last year China launched a program that will soon allow oil to be traded for gold-backed Yuan (Chinese currency) that, if successful, will have major implications for gold, oil, the U.S. dollar and the petrodollar system.

Many of you know that I believe gold will significantly outperform most other major asset classes during the next recession due to the sheer amount of global debt that will test the solvency of the global financial system. But that isn’t the only reason I’m interested in gold. If China is successful with their gold-backed Yuan for oil exchange, it could drive the price of gold even higher as global demand for gold skyrockets under this new program. To understand why the price of gold may jump under this new Chinese program, one should understand how the current petrodollar system works.

The story of the petrodollar system goes all the way back to the end of World War II when leaders from forty-four allied nations met in Bretton Woods, New Hampshire where they agreed to an international gold-backed U.S. dollar system. That system would allow U.S. dollars to be converted back to gold at a rate of $35 per ounce. As a result of the Bretton Woods agreement, there was a new global demand for U.S. dollars.

With growing demand for the dollar, the United States had to make sure the world had enough supply. As I’ve covered in a prior weekly update, the United States can’t directly print money. To meet this demand for dollars, the United States issued debt in the form of U.S. Treasuries. This increase in the money supply led to an increase in asset prices, along with great prosperity.

The United States didn’t take this role as the world’s reserve currency too seriously because we used it to run up massive debts. The world became concerned that the United States wouldn’t be able to repay these debts, so other nations began exchanging their dollars for gold. As our gold reserves dwindled, the United States faced a serious problem. Rather than deal with the problem by becoming more fiscally responsible, President Nixon closed the gold window on August 15, 1971. On that day, the U.S. dollar became a fiat currency, meaning it was backed by the full faith and credit of the U.S. government.

Being a reserve currency allows the United States to run massive deficits and to borrow money at below average interest rates, which is a politician’s dream come true. In order to continue running massive deficits, the United States needed a new way to keep demand for the U.S. dollar high. Fortunately for us, Saudi Arabia needed protection for its oil fields and we needed a buyer for our debt. By 1974, just three years after the United States went off the gold standard, the petrodollar system would be in full swing.

Saudi Arabia wanted weapons and protection for its oil fields. In exchange, we wanted the Saudi’s to price oil exclusively in dollars and invest their surplus in U.S. debt securities or Treasuries. Upon that agreement, the petrodollar was born. A petrodollar is any dollar that is received by an oil producer for the purchase of oil that is redeposited in a Western bank. Less than a year later, OPEC was fully on board with this arrangement, as they agreed to price their oil in dollars in exchange for military protection.

The petrodollar system was inherently advantageous for the United States. While other nations would need dollars to buy oil or get dollars when they sell oil, we could get all the oil we need by issuing more dollars, or debt. This agreement would allow us to exchange a piece of paper, an IOU essentially, in the form of a U.S. Treasury, for a barrel of oil. What a great deal!!

If you’ve ever wondered why so many nations have an export-led strategy regarding the United States, it’s because of the petrodollar system. Under the petrodollar system, if a foreign business needs oil, they would have to go to the costly foreign exchange markets to convert their currency to U.S. dollars. The other way that foreign business can get dollars is to export goods and services to the United States, which will be paid in U.S. dollars. From the perspective of that foreign business, the cheapest way to get dollars is by export rather than the foreign exchange markets. Now you know why so many nations export to the United States – it’s to get dollars!

The new petrodollar system created an immediate demand for more dollars and more U.S. Treasuries. This gave the United States a blank check to spend as much money as it wanted so long as it was providing the world with enough dollars. And given oil demand would continue to rise, along with prices, the United States would be forced to issue more dollars and more debt to keep up with demand. This meant that the United States could, in theory, borrow in perpetuity as long as demand for oil increased.

If you’ve ever wondered why the United States has its fingers on any geopolitical event in the Middle East, it’s because of the petrodollar system. There is no question that the petrodollar system is a national security issue. Without the petrodollar, life in the United States would be very different. Dollars would flow back into the United States, which would end our ability to run massive deficits. All of those dollars returning would briefly cause high inflation until the Fed could raise interest rates high enough to reign in all the extra dollars. Higher interest rates would cause the stock market and asset prices to fall. As you can see, the expansion of the U.S. money supply over the past 40 years has everything to do with the petrodollar system.

The Chinese gold-backed Yuan is unlikely to upend the petrodollar system overnight. While some suggest this is a return to the gold standard, it’s not; there’s not enough gold in the world to back all of the fiat currencies. When a country sells oil to China, who is the largest importer of oil, they will receive Yuan. That Yuan can be used to purchase Chinese made goods, which will help China maintain its dominance as an exporter of goods. If the seller doesn’t need more Yuan or has excess Yuan, they will be able to sell it on the exchange for physical gold. The price of gold won’t be fixed. Those selling Yuan will receive the market price for gold, meaning the price of gold, just like the dollar, will float. The “petroyuan” system just gives sellers of oil an option to receive physical gold, instead of dollars.

The big story with the petroyuan is that it has the potential to increase the demand and price for gold. China is expected to bring this system online in late 2017 or early 2018, with Russia and Iran as expected initial clients – the old “Axis of Evil.” China and Russia have both been buying large amounts of gold over the past year and China has had it gold mines on overdrive. When looking at a chart pattern of gold, there’s a possible head and shoulders reversal pattern that doesn’t complete, according to the research of classical chartist Peter Brandt, until early 2018. Coincidental? Perhaps. The timing and upside potential are very interesting and this just adds to my narrative that gold will outperform in the years to come.

Video Topic of the Week

This week I touch on the petrodollar system, the impending move into gold miners and how this Teflon market claimed another hedge fund manager.

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Portfolio Shield™ Update

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Weekly Sector Commentary

50-Day Moving Average Test

This week I was given some council by a long-time trader. He said to follow the 50-day moving average. When markets are in an uptrend they will follow the 50-day moving average and as they peak, prices will start trading below the 50-day moving average until the downward trend has been set. With the same being true for the downtrend. He suggested that this should not be the only guide because prices can quickly move through the 50-day moving average, but use it in addition to other forms of analysis. This week in the charts, we’re going to focus on the trend of the 50-day moving average and see how it works with my predictions.

Broad Market / Economy

Inflation data this week was up, which gives support to the Fed announcing next week their plans for another rate hike or to begin unwinding their bond portfolio. Consumer confidence remains strong, with respondents saying that the stock market would continue to rise over the next 12 months. Based on the consumer confidence survey, bullish views on the stock market eclipse that of the 2000 highs.

Other data was weak, such as industrial production and retail sales. Those have been discounted by the hurricanes, but we have clearly seen that both have peaked and are in declining trends.

U.S. Equities

The S&P 500 and especially the Nasdaq-100 are very divergent in price from sentiment. The sentiment for the S&P 500 is back to the midpoint and now at 65%, which is low relative to how high the S&P 500 is. Meanwhile, sentiment on the Nasdaq-100 is at 50%, while the index trades at all-time highs. This indicates that prices are high relative to sentiment.

Filed under things that don’t make sense, the S&P 500 closed at 2,500, which is an all-time high on the news of a missile launch, our government revising down GDP projections for next quarter, retail sales missing expectations, industrial production falling, and the potential for the Fed to announce the unwinding of their balance sheet next week.

U.S. Treasuries

Last week Treasury yields were on the cusp of a major breakdown, but DeMark exhaustion signals and sentiment signals suggested there would be at least one last move up in yields before continuing the downward trend. Sentiment on Treasuries this week is down to 63% from its recent high of 80%.

Looking at the 50-day moving average of 10-year Treasuries, yields have mostly been trading under their 50-day moving average since February. The trend is clearly down, but it appears the markets want another confirmation, which is why on Thursday yields moved up to their 50-day moving average and backed off. I expect in the days that follow that the downward trend 9in yields will be confirmed by a failure to sustainably break their 50-day moving average.

International / Emerging Markets

UK stocks, at least those priced in dollars, appear to be on an upward trend. As I showed last week, prices had just moved out of an asymmetrical triangle. Since last week data coming out of the UK hasn’t been that strong and prices have been flat. The 50 and 100-day moving averages are playing catchup in this upward move, suggested a potential buy once this upward trend is confirmed.

Energy Sector

I’ve had a renewed interest in the energy sector since it’s been in a downtrend since January. Based strictly on price charts, there are bottoming patterns forming in the oil explorers and producers. If what I’m seeing is correct, the inverse head and shoulders pattern doesn’t complete until mid-October, which could lend itself to an opportunity to be long the oil producers.

U.S. Dollar

The dollar has moved below a major topping pattern that started back in January 2015. After the post-election peak of the dollar, it has fallen for nearly nine months straight. The post-election bounce appears to have given those who wanted to sell dollars a fantastic opportunity to do that.

Sentiment on the dollar remains low at 24%, suggested a near-term bounce should be in the cards. Looking at the trade-weighted dollar, a bounce to confirm the 50 or 100-day moving averages is expected, but I don’t see that as a trend change.

With the U.S. economy continuing to weaken and the petrodollar system under attack, I believe the dollar is headed lower. My view is also consistent with MSA’s momentum work, who has also called for a weaker dollar.

Commodity Producers

Both gold and gold miners broke out to the upside last week, but as I mentioned, the breakout wasn’t on high volume and that was followed by a peak in sentiment and a DeMark exhaustion signal.

Prices have backed off their peak, validating that this wasn’t the big breakout move, but it’s suggesting that move isn’t far off. Peter Brandt, a classical chartist, recently posted his gold chart suggesting that traders wait to buy the next dip around $1,250/oz. Looking at the moving averages, the 50-day moving average is right around that mark.

Looking at the gold and silver miners, they are both retracting back to their moving averages. After a major move down, the miners have been trading on both sides of their 50-day moving average since the first of the year. When analyzing past breakouts, a confirmation of the 50-day moving average isn’t necessary when the breakout is on strong volume over the days that follow the breakout. When the breakout is weak, from a volume perspective, confirmation of the moving averages validates the trend.

Even looking at the weekly charts there is confirmation among the moving averages, because gold bounced off its 100-week moving average a couple weeks ago. What I find interesting is that the 50-day and 50-week moving averages are right near the same price point. This is our final buy signal that means gold, along with the gold and silver miners, are about to embark on the first major leg up. If this is a resumption of the gold bull market, be excited, because long-term breakouts usually have three major uptrends. We’re currently positioned right near the bottom of the first uptrend.

Agricultural Commodities

Agricultural commodities have been moving up off the bottom that was formed a couple weeks ago. Volume has been higher than normal, showing that buyers are getting involved. In Peter Brandt’s most recent report had a section titled, “Grain markets – a bottom of generational magnitude could be forming.” He goes on to say that grains or soft commodities tend to have very long bottoming patterns that can run several decades before making a rapid move up. He believes we are seeing bottoming patterns in several soft commodities, which is an early bullish sign for agricultural commodities.