Weekly Economic Update 09-22-2017

The Petroyuan Is Coming

As I was writing last week’s update about the potential end of the petrodollar system, Venezuela announced that they are planning to sell their oil for a different currency other than the dollar. Not even forty-eight hours later, they announced they will be selling their oil exclusively for Yuan. That decision is just one more in what is likely to be the slow demise of the petrodollar system.

For those that missed last week’s update, which I encourage you to read, the petrodollar system is one where oil producing nations sell their oil for U.S. dollars and reinvest any excess dollars back into U.S. Treasuries. This cycle of oil for dollars is referred to as the petrodollar system. It has allowed the United States the ability to print a piece of paper in the form of an IOU, or a U.S. Treasury bond, in exchange for a barrel oil. This is an extremely lucrative arrangement for the United States that has allowed us to run massive deficits since the early 1970’s because the demand for oil, and dollars, has been increasing for nearly fifty years. Meanwhile, all other nations are forced to get dollars, either through foreign exchange markets or by exporting to the United States, in order to buy oil.

While this system has benefited the United States, there is growing concern about how the United States is going to deal with an estimated $100 trillion of unfunded liabilities that it owes to its citizens. Since much of this unfunded liability is owed to the Boomers, there is a real concern around the world that the United States is simply going to inflate its way out of the problem. While this might work for the United States, high inflation isn’t good for those with U.S. dollar reserves, such as China.

China holds about $3 trillion U.S dollars in reserve, which can be used to purchase oil. Simply, if the United States inflates its way out of its $100 trillion-dollar problems, the $3 trillion China has will buy less oil. For a nation that has a large population and is expanding, high oil prices are a serious problem. China and other emerging nations want cheap energy prices to fuel economic growth. With oil priced in dollars, China has no way to control oil prices, which is why they created the petroyuan.

The purpose of the petroyuan is for oil sellers to receive Yuan instead of U.S. dollars. But unlike dollars, any Yuan received for oil will be fully convertible to physical gold on the Shanghai and Hong Kong exchanges by late 2017 or early 2018. The petroyuan system will give oil sellers the option to receive physical gold for their excess Yuan, rather than U.S. Treasuries for their excess dollars, as dictated by the petrodollar system.

If you’re worried that this is going to be the abrupt end to the petrodollar system and the American way of life, it’s not. While Russia, Iran, and Venezuela have already signed on to sell oil to China for Yuan and Qatar is selling natural gas to China for Yuan, they aren’t selling all of their oil for Yuan. It’s possible that will change once the Yuan-for-gold exchanges are active, but for now, oil sellers are only selling enough oil to meet their need for Yuan.

Over the longer term, oil priced in gold is very beneficial for emerging economies. Oil, when priced by gold, is very inexpensive and prices are stable. When looking at a historical chart of oil, the price of oil is relatively flat for one-hundred years up until the petrodollar system began in the early 1970’s. It’s not until 1972 where there are large boom and busts in the price of oil. From a macro perspective, a conversion from the petrodollar system to a gold-backed petroyuan system is bearish for oil prices. It also lends some credence to why the major oil companies in the United States are starting to lay off employees again despite oil prices hovering around $50 per barrel. Oil executives undoubtedly know that if China is successful then oil prices are headed down and are likely to stay low for a long time.

The petroyuan concept was born back in 2009 when China talked about having a stable benchmark for an international reserve currency. Three short years later, Chinese gold imports began to surge. Their gold reserves in 2015 are estimated to be around 1,000 tons and they have jumped to approximately 1,800 tons two years later. Not to be left out, Russian gold reserves were about 800 tons in 2011 and are now about 1,600 tons. The rise in gold reserves is strong evidence that China and Russia both foresaw a need for more gold.

There are many people who don’t think this will happen and they like to point out that it is currently very difficult to get gold out of China. Like anything new, with China selling this concept to Russia, Iran, Qatar and now Venezuela, they are now in a position where they are forced to deliver. Failure to create a convertible Yuan-to-gold contract will just eventually push those other countries back to the petrodollar system.

As I mentioned before this won’t cause an immediate end to the petrodollar system or the United States’ ability to run large budget deficits. The reason for that is trade. Most foreign economies are set up to export to the United States and in order for that to be a profitable arrangement, those countries need their currency to be worth less than the dollar. Which means there still will be a demand for dollar-based assets because one way to artificially keep a currency below that of the dollar is to buy dollar-based assets, such as U.S. Treasuries. Even though the United States runs a trade deficit with our foreign trading partners, that money has to come back in another form. The most common way it comes back is when foreign holders of dollars buy our debt in the form of U.S. Treasuries.

If this program is successful, even on a small scale, it will have serious long-term repercussions for the United States. To give you an example, we don’t hold very much in foreign currency reserves because we don’t need to. If there’s something the United States wants to buy, we simply print more money, whereas our foreign partners need to hold foreign currency in reserve to buy oil and facilitate trade. Under a system that converts Yuan to gold, foreign countries won’t need to maintain a large reserve of dollars—meaning demand and need for dollars will fall. Furthermore, the United States will lose its ability to run large budget deficits. Since our economy is built on the expansion of credit and dollars, the contraction of both means that the prosperity that we have come accustomed to will slowly go away.

In addition to the recent change by Venezuela, Russian President Vladimir Putin instructed his government to pass legislation that would replace the dollar as the currency of business at Russian seaports. If that happened it would be another blow to the dollar. With massive deficits and even larger unfunded liabilities, the United States may find itself without the ability to continue borrowing money to solve its problems. The ramifications of that will affect the lives of every citizen in our country. In a future update, I will review the implications of such a situation, options available to us, and more importantly, your money.

Video Topic of the Week – Quantitative Tightening

I explain how the Fed’s decision to unwind its $4.5 trillion-dollar balance sheet is likely to affect stock and bond prices.

Chart of the Week – Stock Market Bubbles

Historically stock markets bubble when prices reach their 90th percentile on their price-to-median-10-years-earnings.

Portfolio Shield™ Update

The strategy continues to perform within expectations.

Weekly Sector Commentary

Broad Market / Economy

The Fed announcement to unwind its $4.5 trillion-dollar balance sheet didn’t come as a big surprise. Starting in October they will allow $10 billion dollars a month to fall off, then increase that to $30 billion next year with the plan to unwind about $600 billion a year. It’s going to take many years for them to unwind all of these positions and it’s unlikely they will be successful. Once the economy recesses, you can bet the Fed will be back buying bonds.

Many people think this is bullish for bond yields and bearish for bond prices. This supports the reaction in the Treasury market on the day of the Fed announcement. Unfortunately this is an incorrect view.

When the Fed came out with Quantitative Easing, yields rose as people sold their bonds to buy stocks. With the Fed buying up all the supply, investors were left with a choice to buy stocks or stocks. And based on how the stock market rose, it’s obvious what investors did.

The logic is that as a new supply of bonds his the market that yields will have to rise to entice buyers. This is also not true. When the Fed started buying all the bonds, it took supply away from those who normally buy bonds. As bonds become available, those buyers will switch back to buying bonds instead of stocks. Hence why tightening usually leads to stock prices and bond yields falling.

I would subscribe to the notion that this would lead to higher bond yields if the Fed was buying bonds because nobody else would. That just wasn’t the case. The Fed just bought up all the supply leaving bond investors no choice but to buy stocks. The purpose of Quantitative Easing 1-3 was to create a stock market bubble and it did just that. Quantitive Tightening, which is what the Fed is doing by raising interest rates and selling off its bonds, will lead to a contraction in the money supply and asset prices.

I probably need to dedicate more time to this in the weeks to come, but I’m shocked by what happened at the press conference. Yellen admitted that the Fed didn’t know why inflation was not reaching their target of 2%. She danced around questions of the large asset bubble the Fed created. The Fed members all downgraded their expectations for future rate hikes, inflation, and growth. What?!?

In one press conference, the Fed made every indication that they were clueless, but are going to proceed with tightening monetary policy anyways. I’ve stated before that the Fed creates every expansion and every recession. The evidence is right in front of us; they’re about to do it again.

U.S. Equities

U.S. stocks remain largely muted this week, despite the Fed announcement and the geopolitical events going on in the world. It just goes to show how immune this market is to any news, because nothing seems to phase it. Be forewarned, because stock prices usually fall when the Fed tightens.

Sentiment on the S&P 500 closed the week at 75%, which was a big reversal from the 50% level it saw last week. The 75% level is about where sentiment has peaked in the past. Will this lead to a larger reversal or is this just a pause in the slow grind up?

U.S. Treasuries

Treasuries needed a catalyst to confirm their downtrend and they got one when the Fed announced they were going to unwind their balance sheet. Yields moved up, but only to revisit their 50-week moving average. This retest of the moving average was inevitable, barring a major market moving event because if prices hold below the moving average, it confirms yields are in a downtrend. If the downtrend is validated, which it appears to be doing now, then the next move down in yields is likely the bigger move that I’ve been looking for.

As for why there was this bump in yields, it is mostly due to the number of speculators who were long Treasuries. Several weeks back I pointed out that there was a near-record number of long speculators. Moves like this are designed to flush them out and it worked.

Sentiment has dropped to 52% for the week, but anything over 50% is still bullish – this is for bonds, not yields. As long as bond sentiment is over 50%, it still confirms the bullish trend in bond prices (a bearish trend in yields), even though bond prices slipped this week.

The other factor coming into play is the Fed. Quantitative Tightening should be bearish for yields and bullish for bonds.

International / Emerging Markets

I mentioned in prior updates that I like the chart pattern and trend of United Kingdom stocks. They haven’t really shown any sign of a resumption of their uptrend. Even worse, on Wednesday when the Fed announced they were tightening monetary policy, there was a sharp reversal in UK equities. It’s hard to like equities when the Fed is going to start tightening because the probabilities are high that this will cause a global recession.

Energy Sector

If there’s one sector where hedge funds and speculators are overly bullish, it’s the energy sector. With rumors that OPEC may extend production cuts and possibly add export cuts (they’ve been cheating by continuing to export from wet storage as they implement production cuts), and with the recent EIA reports suggesting that there will be increased demand and higher prices in the second half of 2018, there’s a real possibility of seeing $60 oil.

That is until the economy recesses, which at that point oil prices commonly bottom with the economy. That aside, I’m looking at a reversal pattern in the oil producers’ ETF. The chart pattern doesn’t complete until mid-October, meaning there may be an opportunity to take a position in this sector if the remainder of this pattern fills in to validate a potential reversal.

U.S. Dollar

As I have mentioned in prior updates and in the chart pack, the dollar has been in what appears to be a major multi-year topping pattern. Dollar sentiment over the past couple weeks has been very bearish and when sentiment and oversold indicators are in sync, a reversal often happens.

With the Fed announcing they are going to start tightening monetary policy, the dollar bulls came out in droves and so far, have been met my dollar sellers. Every attempt by the bulls has failed. This doesn’t mean a short-term reversal shouldn’t happen, but it shows that those with dollars want to sell them. Given what we know about the potential petroyuan system, it’s easy to see that there are other nations who have reason to reduce their dollar reserves.

So far it appears that a weaker dollar is coming, which is bullish for commodities.

Commodity Producers

Gold sentiment plunged this week to 38%, and anytime sentiment falls below 50%, there’s likely a larger move down in prices coming. While gold tested its 50-day moving average, I don’t see any conviction that it will hold. Just like with Treasuries, I expect gold to revisit its weekly moving averages with are closer to $1,250/oz. For those regular readers, you already know that $1,250/oz. is right at the price range Peter Brandt (classical chartist) called as the next buy point. I have a hunch he will be right.

If that is the case and gold slips, the gold and silver miners will too. Silver miners fell below their daily and weekly moving averages, but this isn’t unusual. The gold miners are testing their 50-day moving average, but looking at volume, I don’t see any conviction here either. Again, now that I have reliable sentiment data, the probabilities of the mining stocks falling a bit further is high.

Once the uptrend is confirmed, I believe we are looking at the long-awaited bottom in gold and silver miners. If correct, this will kick off the next bull market in commodity producers, which I intend to take advantage of.

Agricultural Commodities

Agricultural commodities have been slowly moving up off their recent lows set back about a month ago. Volume has been steadily increasing along with price, which is a positive sign. I am bullish on this sector as it remains one of the most unloved sectors in the market. Often when trends change, those hated sectors can become very popular. I still anticipate selling when prices get back into the low $20’s unless there’s a breakout over $20.30 per share.