Oil & China, FXI:DBO Price Ratio

Here's an interesting one. It shows that the ratio between iShares FTSE/Xinhua China 25 (FXI) and PowerShares DB Oil (DBO) has been pretty consistent since the start of 2009. It suggests that these two funds are responding to the same underlying factor(s).

Good Timing?

On June 29, I made this post 分析金矿股票图表 in Chinese, in which I discussed the signals I was getting from the gold mining stocks. I had several charts, the first of which showed that gold miners signaled a market turn in late February, right about the time that Robert Prechter made his call for a near-term bottom; Marc Faber turned bullish around the same time.

I then showed a chart of 2008 and I highlighted the March and July periods. I've commented before about how I believe 2009 is unfolding similarly to 2008, and I though July might be a period for a downturn similar to the one caused by Fannie and Freddie in 2008. Gold miners started falling in mid-June, along with commodity prices, and I wondered if this wasn't sending the same signal as in 2008, when oil prices peaked in late-June early-July and then went south quickly. I posted this graph on that date:


Here's how things have done since:


Prechter thinks we'll have a rally in late summer, just like 2008. I think my 2009 framework holds up, but then the question is what happens this fall...

Note: if the charts on not visible, try clicking on the post title. If they're still not showing, click through to see them. Sina is spotty with their treatment of hot links.

What can deliver deflation?

In the previous post on Andy Xie's "Fear the Dark Side of China's Lending Surge", I wrote that the central banks need deflation to knock inflation speculators out of the commodity market. The easiest way to achieve a quick drop in commodity prices would be a dollar rally. And one may be on the way, as Kathy Lien points out in U.S. DOLLAR: WHAT CAN BREAK THE RANGE? :

Although the summer doldrums should reduce volatility in the currency market, the apex of the triangle formations in EUR/USD, GBP/USD and USD/JPY point to a large expansion in volatility (ie. a possible breakout move) as early as next week.

What Can Trigger a Breakout?

Sometimes nothing more than the lack of liquidity could cause a breakout in the currency market. No major surprises are expected in U.S. economic data next week with only housing market reports, durable goods, the final release of first quarter GDP and the Federal Reserve interest rate decision on the calendar. If the Fed expanded their asset purchases or becomes more optimistic, it could trigger a break in the EUR/USD, but we expect the central bank to keep the tone of the FOMC statement basically unchanged. The only real possibility is a mention of exit strategies, but so far currency traders have shrugged off similar talk by the ECB and BoE. Instead, what could trigger a breakout are exogenous events such as growing tensions with North Korea, downgrades or higher taxes. The late afternoon sell-off in the dollar on Friday was driven by speculation that rating agency Moody’s could downgrade California’s debt rating. California’s fiscal finances are a mess, prompting Governor Schwarzenegger to even consider a flat tax.

Forex Traders Adjusting Positions

A few weeks ago, we talked about the exaggeration of dollar short positions in the futures market but these positions have recently been trimmed.

Best of all would be for a U.S. dollar rally to accompany a stock market rally, with bullish investors claiming that lower oil prices will boost the economy.

谢国忠 Andy Xie: Fear the Dark Side of China's Lending Surge

Here's a long and important section of Andy Xie's latest:

The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

Commodity prices have skyrocketed since March. The Reuters-Jefferies CRB Index has risen by about one-third. Several important commodities such as oil and copper have doubled in value from this year's lows. As I have argued before, demand from financial buyers is driving commodity prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.

Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.

Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.

Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.

For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation.

The worldwide rally of commodities and equities is a speculation led bubble based on future growth expectations that have no basis in reality. Economic data continue to point to a very weak U.S. economy, check out a recent post by Mish on truck and rail traffic. The Baltic Index is up because the Chinese demand requires shipment of commodities, but rail traffic in the U.S. doesn't show resource demand.

Andy Xie's comments on ETFs and the implications for monetary policy are important. Never before have commodity markets been so accessible to retail investors, yet the commodity markets themselves remain relatively small compared to stock and bond markets. There's a lot of room for growth, should investors decide they want out of equities and into commodities. This also means investors can exit the U.S. dollar and financial assets at a moment's notice.

In the early 1980s, Ed Yardeni dubbed the inflation hawks in the bond market "bond vigilantes". Today, there are still bond vigilantes, but now retail investors can join the game via derivative ETFs such as ProShares Ultra Short 20+ Year Treasury (TBT), or various commodity ETFs such as SPDR Gold Shares (GLD), PowerShares DB Agriculture (DBA) or PowerShares DB Oil (DBO).

Financial markets don't do what everyone is expecting though—"the market" is the master of misdirection. If investors anticipate high inflation, they will pour into commodity funds and drive up interest rates. The government may try to restrict commodity speculation, and that could be a part of upcoming financial reforms. Otherwise, the Federal Reserve and other central banks will be forced to raise interest rates and drain liquidity from the system, and that will touch off another round of deflation.

The speculators are in the driver's seat because they suspect (many would say they "know") that the government finds another deflationary event unacceptable. They are playing chicken with the central bank because they believe central banks will swerve their inflationary Fiat in the face of the deflationary Mack truck. The behavior of speculators guarantees very high inflation if the central banks do not curtail credit. In order to have the "healthy" inflation the central banks want, they must restrict access to commodity markets and/or chase the speculators out. A well-timed liquidity drain or surprise rate hike would put the central bankers in the driver's seat of the Mack truck and leave the speculators packed in the Fiat.

I do not believe the central banks can create the inflation they desire while the world is watching. There is a natural law underpinning the world that cannot be defied for long. In the absence of central bank inflation, speculators are setting up the next round of deflation as high resource costs drain the pockets of consumers and business alike. The central banks cannot print money unless people are willing to hold it, i.e .unless there is a healthy demand. Recently, demand for cash was so strong that the velocity of money plummeted. In a high velocity environment, with very low demand for money, central bank printing is suicidal. The central bankers need to keep demand high, and they will do by keeping the spectre of deflation alive. Without it, they can only fail.