Stay cool and don’t panic!
Source of picture: www.wired.com
By John Richardson
THE growth of the carry trade US dollars – leading to a sharp depreciation of the greenback and possibly of many other unintended consequences – represents a major threat to the chemicals industry in 2010.
Any corporate planner with her or his salt should factoring in, and hedging against, the danger that the many warnings about the damage from this trade come true.
Warnings have been issued over the last few weeks by the Chinese government, the International Monetary Fund (IMF), Hong Kong chief executive Donald Tsang and Dallas Fed chairman Richard Fisher.
Economist Nouriel Roubini, who accurately predicted the current economic crisis, has been proclaiming loudly from every available rooftop that this is the “mother of all of carry trades”.
He believes that, potentially, it could cause even more damage to the financial system than the crisis from which are still struggling to recover.
But this blog was able to find two people who disagreed: A UBS analyst and a hedge-fund trader. Nothing to worry about, then!
Just as a reminder, the carry trade involves borrowing at zero interest rates in dollars (because of the ultra-loose Fed monetary policy) – and also shorting the US currency on the assumption that it will depreciate.
As the dollar has tumbled – creating extremely good returns – investors have also piled into equities and commodities, incurring very high leverage.
Oil increasingly moves in inverse correlation to the dollar these days so, I suppose, this whole business has gained its own self-perpetuating momentum: The more that investors short the dollar, the more it goes down and the more crude goes up. Sounds like daylight robbery.
Stronger crude – which we’ve frequently said doesn’t reflect current supply and demand – is seen as a false sign that the world economy is in firm recovery.
And so, hey presto, equities rise in response to higher oil prices, resulting in yet more fat profits for the speculators.
The dollar could appreciate by as much as 25% if, all of a sudden, traders are forced to cover their shorts (a phrase that, I am afraid never ceases to appeal to my puerile sense of humour), warns Roubini.
He predicts that one of four events could trigger this new financial calamity:
*The dollar value cannot fall to zero and at some point it will stabilise. The cost of carry would then become zero rather than negative (no more money being made on shorting the greenback)
*The Fed cannot suppress volatility forever. Its $1,800bn purchase plan of mortgage-backed securities and government agency debt such as Fannie Mae’s etc will be over by the Spring
*If growth is on the upside in the third and fourth quarters, markets may start to expect Fed tightening sooner rather than later
*A flight from risk could occur due to concerns over a double-dip recession or a geopolitical crisis – e.g. a US/Israel and Iran conflict
Before listing some of the possible implications for chemicals, it’s worth adding the following context.
Big increases in Asian property prices (for example, Hong Kong’s are up by 28% this year) start to add up in light of the Fed’s ultra-loose monetary policy that’s prompted the carry trade.
Asian countries have been forced to follow the Fed in order to prevent their currencies from appreciating too much.
This is creating dangerous real-estate bubbles in Singapore and South Korea as well as Hong Kong, with all the associated higher levels of consumption which come with the property wealth-effect.
China is different as it’s re-pegged the Yuan to the dollar.
But the country’s huge economic stimulus package has created the well-documented big rise in property prices and a boom in auto, home appliance and other retail sales.
Meanwhile, China is also benefiting from improved export competitiveness as a result of its currency being reconnected to the weaker greenback.
So those chemicals corporate planners worth their salt should be worrying about:
*The risk of being on the wrong side of overbuilt inventories, or even just the normal 45-60 days of working capital tied up in raw materials, when and if crude takes a tumble
*Confusion over sustainable levels of chemicals demand-growth in housing, autos etc in Asia. If the Fed tightens in response to worries over the impact of excess liquidity so will the rest of the world
*Damage to underlying, or fundamental, demand caused by crude being too high at this point in the economic recovery. My fellow blogger, Paul Hodges, points out that this concern is high within OPEC.
*Chemicals import volumes into China destined for re-exports as finished goods have been supported by the weaker Yuan. These imports could obviously decline if the dollar lurches upwards
*US petrochemicals producers have benefited from dollar weakness and the fall in natural-gas prices relative to crude (70% of US ethylene is derived from natural-gas liquids). Thermoplastic exports are up 16% in the year-to-date with domestic sales down nearly 14%, according to the latest American Chemistry Council (ACC) weekly report. So, again a surge in the greenback would threaten this much-needed compensation for a weak home market.
When might the carry trade unwind? Nouriel Roubini is not prepared to offer any prediction, but warns that the longer this bubble inflates the worst the consequences will be when it deflates.