Shortage of the US Dollar as Pretext for More Inflationism

Newswires say there has been a shortage of US dollars in the global financial system.

Bloomberg reports,

Central banks rebuilding foreign- exchange reserves at the fastest pace since 2004 are crowding out private investors seeking U.S. dollars, boosting demand even as the Federal Reserve considers printing more currency.

After falling to an all-time low of 60.5 percent in the second quarter of last year, the dollar’s share of global reserves rose 1.6 percentage points to 62.1 percent in December, the latest International Monetary Fund figures show. The buying has left the private sector with $2 trillion less than it needs, according to investment-flow data by Morgan Stanley, which sees the dollar gaining 8.2 percent in 2012, the most in seven years.

While the Fed has created more than $2 trillion under its stimulus programs since 2008, the flows signal that there may actually be a shortage of dollars to meet demand as Europe’s debt crisis deepens and the global economy slows. The dollar has risen 3.5 percent since the end of April against a basket of the most-widely traded currencies even amid speculation that the Fed, which meets this week, may undertake the type of stimulus measures that weakened it in the past.

“The market often assumes that people are long dollars, but many of those dollars are held by central banks, which are unlikely to move out,” Ian Stannard, head of European currency strategy at Morgan Stanley in London, said in a June 13 interview. “That leaves us with the private sector, which is short,” meaning they don’t have enough of them, he said. “In an environment where we see a global slowdown, the dollar will be well supported.”

Dollar Scarcity

Morgan Stanley says the potential scarcity of dollars among foreign private borrowers represents the U.S.’s net position with lenders abroad of minus $2.4 trillion, adding $4.8 trillion of U.S. financial assets held by central banks, and subtracting $500 billion of foreign official assets held by the U.S.

That equals about $2 trillion of demand from foreign private banks and companies. The gap has expanded from $400 billion in 2008, according to the New York-based firm. In 2002, there was a dollar surplus of $900 billion, the data show.

The shift in the share of global forex reserves weighted towards the US dollar hardly translates to a US dollar ‘shortage’. But it can be made to look that way.

Instead, these accounts for symptoms of capital flight (see chart below of deposits of foreign lenders at the US Federal Reserve), ongoing liquidations (loan repayments margin calls etc..) and growing concern over a dysfunctional banking system, which has been magnified in Europe.

Chart from Bloomberg

The statement “many of those dollars are held by central bank” are manifestations of such concerns or of distorted price signals where politicians arduously struggle to protect privileged institutions from market forces through massive interventions. The ensuing uncertainty from regulations and political directions prompts the private sector to seek refuge in central banks than to operate normally.

The innuendo behind the dollar shortage analysis nonetheless represents the clamor for the FED to inject more money into the system.

As the great Ludwig von Mises once wrote,

In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.

Solve the problem of inflation with even more inflation. Yet people forget inflation is a policy that will not and cannot last.

MF Global Holding’s Liquidations and the November 17th Commodity Prices Rout

Aside from China’s proposed increase on credit margins for Silver, I think that the unwinding of mostly commodity assets of bankrupt MF Global Holdings has had much to do with the rout in the commodity markets last Thursday (November 17).

The above chart from stockcharts.com, is the weekly charts for gold, silver and CRB indices which exhibits the steep decline last Thursday.

From Businessweek-Bloomberg dated November 16th, (bold emphasis mine)

The trustee liquidating commodities broker MF Global Inc. filed papers yesterday setting up an emergency hearing tomorrow for approval to require the accelerated filing of claims.

Six customers filed a motion asking the bankruptcy judge to overrule the trustee and allow customers to take out 90 percent or more of their collateral.

In papers filed yesterday referring to his “vigorous efforts,” the trustee said the “precise size of and the reasons for the shortfall in segregated accounts are not yet known by the trustee, law enforcement, and other officials and regulators conducting investigations.”

If the trustee has his way, there will be a two-track process where commodities and securities customers must file claims by Jan. 27 to receive the maximum distribution of so- called customer property. General creditors must submit claims by May 28.

James W. Giddens, the trustee for the MF Global broker, said he has already distributed about 3 million commodities contracts in 17,000 customer accounts, together with $1.55 billion in collateral, to 12 or more other brokers. Accounts that weren't transferred by Nov. 11 are undergoing an “orderly liquidation,” Giddens said.

Giddens also said he's looking for other brokers to accept bulk transfers of 450 customer accounts for securities. He also asked a judge to let him transfer about $520 million in collateral to commodity customers whose accounts consisted solely of cash on Oct. 31.

The trustee said he will review customer claims on a “rolling basis” as they are filed. Given what he called the “relatively poor state” of the books, the trustee said he hopes to make additional requests to the court for further distributions of so-called customer property.

Giddens was unable to transfer accounts immediately because about $600 million of customers' collateral is missing. Consequently, open contracts transferred to other brokers weren't accompanied by all the collateral customers had on account with MF Global.

Six customers in their motion filed yesterday contend the trustee should be giving them at least 90 percent of the collateral. They arrive at the figure saying that the $600 million in missing cash is about 10 percent of the $5.5 billion supposedly held for customers.

Missing cash, accelerated filing (November 15th) of claims and orderly liquidations for accounts that have not been transferred seem to coincide with November 17’s rout in commodity prices.

I expected this liquidation induced volatility from MF Global Holdings to happen a week ago. Apparently legal obstacles may have delayed the process from taking place until late this week.

While it is unclear if the procedural liquidations has culminated, the likely effect from this should be temporary which means current weakness in commodity prices may prove to be a great buying opportunity.

Sectoral Performance In US, China And The Philippines

``[Asia is] a very different dynamic compared with the rest of the world. Most banking systems in Asia are flush with liquidity as they have a surplus of deposits over lending. So if [corporates] have in the past financed in the international bond markets, when it comes to refinancing they can turn to the local market alternatives because plenty of banks are still willing to lend”- Jason Rogers, a credit analyst at Barclays Capital Asia-Pacific corporate bonds surge

In bubble cycles, the object of a speculative bubble, after a bust, normally takes years to recover.

To cite a few, the Philippine Phisix following the 1997 Asian Crisis episode hasn’t fully recovered even 12 years after, Japan’s Nikkei 225 and its property sector remains in doldrums following the bust in 1990 (that’s 19 years!), and the technology centered dot,com bust during the new millennium in the US has left the Nasdaq miles away from its peak, 9 years ago.

The recent bubble cycle phenomenon evolved around the US real estate sector which had been funded by the financial industry. In short, these two sectors-financials and real estate accounted for as the epicenter of the bubble cycle crisis. So given the nature of bubble cycles, I originally expected the same dynamics to unfold.

The fundamental reason for this is due to the market clearing process or the process of liquidating clusters of malinvestments acquired during the bubble.

And since bubble blowing or the “boom” phase is a process underpinned by policies that is cultured by the markets over time, the liquidation or the “bust” phase likewise employs the same time consuming process but in reverse.

But I guess this dynamic doesn’t seem to be the case today or put differently, this time looks different.

Why?

Because US money managers have largely been overweighting the financial sector, see Figure 5.

Figure 5: Bespoke Invest: Institutional Sector Weightings

According to Bespoke Invest, ``money managers collectively have 18.5% of their long portfolios in the Financial sector, which is the highest weighting for any sector. Technology ranks second at 16.8%, followed by Health Care (12.9%), Energy (12%), and Industrials (10.3%).

``The second chart compares these weightings with the sector weightings of the S&P 500. As shown, institutions are overweight the Financial sector the most and underweight Consumer Staples the most.”

Obviously, the enormous backstop provided for by the US government to the US financial sector has circumvented the natural process of liquidations from fully occurring.

Hence, the intriguing outperformance led by the money managers piling into a sector under the government “umbrella” to seek profits or “economic rent”.

Yet, despite such outperformance, government intrusion to the industry will likely result to more systemic distortions.

To quote Professor Mario Rizzo in a recent paper ``These are agents whose discretionary behavior, insulated from the normal discipline of profit and loss, can significantly affect the course of economic effects. Thus, discretionary behavior on the part of monetary authorities (the Fed), fiscal policy makers (Congress or the Executive), or even in some cases private monopolists, can increase uncertainty faced by most economic agents (“small players”). They will have to pay more attention to trying to guess the perhaps idiosyncratic behavior of the big players. Economic variables will become contaminated with big-player influence. It will become more difficult to extract knowledge of fundamentals from actual market prices.”

Again, pricing signals are becoming less efficient due to government intervention (more difficult to extract knowledge of fundamentals from actual market prices) and is likely to heighten systemic risks (can increase uncertainty faced by most economic agents) arising from the asymmetric behavior of the industry participants shaped by regulators (insulated from the normal discipline of profit and loss).

In combination with the toxic assets stacked in the bank balance sheets, I would remain a skeptic over US financials.

Interesting Parallels In China And The US, Possible Opportunities

It is interesting to see how some parallels can be gleaned from the institutional interest in US stocks and in China’s recent sectoral performance.

While Financials, Materials, Consumer Cyclicals, Energy and Industrial outperformed the S & P 500, in China, Energy, Materials, Financials, Technology and Industrials constituted the top 5 during the latest run on a year to date basis, see figure 6.

Figure 6: Bespoke Invest: China’s Sectoral Performance

In other words, except for Consumer Cyclicals in the US and Technology sector in China, there seems to be some common interests from respective domestic investors-energy, materials, financials and industrials.

In the Philippines, the top 3 sectors have been Mining and Oil, Industrial (energy) and holding companies, whereas financials and services (telecoms) have been laggards.

Except for the financials, basically we see the same pattern playing out.

More interesting insights from Bespoke Invest, ``Sector performance in China paints an interesting picture. In typical selloffs, sectors that lead the rally see the steepest declines, while laggards in the rally tend to outperform. In this selloff, however, this trend is much less evident. The chart below shows the average performance of Chinese stocks by sector during the rally and since the peak on 8/4. While Energy led the rally and has seen the sharpest decline, in other sectors the relationship has been much less evident. For example, Utilities and Telecom Services were in the bottom four in terms of performance during the rally, but during the decline they have also been among the weakest sectors with the second and third worst performance.” (emphasis added)

Given the degree of corrections, it appears that China’s financials are on the way to outperform but could still play second fiddle to Energy.

So while I would remain a skeptic over US financials, it’s a different story for China and for Asia.

Nonetheless if we follow Dennis Gartman’s 7^th rule of his 22 trading rules, ``Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones”, then this would imply that energy, materials and financials could be the best performing sectors over the coming years and could be the most conducive place to be in to achieve ALPHA.

That’s also because China has aggressively been bidding up global resource and energy stocks, for reasons we cited in China's Strategic Resource Accumulation Continues.

Finally, this brings up a possible “window of opportunity” arbitrage for the Philippine markets. Since the local financials have severely lagged the recent rally and IF the same US-China patterns would play out sometime in the future, then positioning on financials on market weakness looks likely a feasible trade.

In addition, the underperformance of the telecom sector which has patently diverged with technology issues has piqued my interest and could be a point of discussion for another day.