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Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets

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Connecting the dots between the decline in the need to hedge to a decline in the demand for credit, and looking at early harbingers of the oil and scrap industries.

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Last week in A Global Macro Paradigm Shift I suggested that the decline in global FX reserves was indicative of falling Chinese reserve accumulation, and that could be flashing warning signals.

China FX reserve accumulation is a large source of global demand for both financial assets and commodities. The US exports the reserve currency and China imports US dollar denominated assets. History has shown that when FX reserves decline on a YOY basis, as they appear to be doing now, it has the potential to manifest itself into a financial market disruption.

It's possible the yuan is rallying because there are fewer dollars being exported to China with which to convert to yuan to maintain the peg. Last week I also noted that declining FX reserve accumulation might explain some of this weakness in copper and the cyclical semiconductor space.

Two of the most cyclically sensitive market indicators are the price of copper (HG) and the Semiconductor Index (INDEXNASDAQ:SOX) both of which are highly correlated with each other and can be seen as a proxy for Chinese economic activity. Copper and the SOX both peaked in Q1 2011 and have made lower highs while US stocks (S&P 500) have made higher highs. This is notable divergence and should not be ignored.

This is no doubt showing up in the performance of copper and other metals such as the highly cycle price of scrap. Friday Bloomberg Businessweek reported that copper prices saw one of their biggest weekly drops of the year.

Copper fell, capping the biggest weekly drop in three months, as signs of slowing scrap-metal purchases and bank lending in China fueled concern that demand will weaken as the global economy sputters.

Scrap discounts to new metal widened 25% in the past three months as demand slumped in China, the world's biggest user, according to Metalsco Inc., a St. Louis-based recycler. In China, banks extended 623.2 billion yuan ($99.5 billion) of loans last month, below the 700 billion yuan median estimate of analysts in a Bloomberg survey.

It's amazing what you can learn by bellying up for a couple hours after work at the local watering hole. Friday I was enjoying a couple of pints and separately encountered two good friends who are both successful businessmen operating in cyclically significant businesses. The first is a former Wall Street investment banker who now works for a conglomerate primarily focused on the auto industry with domestic operations as well as operations in Latin America and Asia. The second runs a large family-owned multifaceted steel business operating in erection, fabrication, and mechanical installation. I had expressed to both of them that monetary aggregates that I follow were showing a big drop off in the demand for money. I didn't need to tell these guys; they are both on the front line.

My friend in the auto business asked if I had read about how China was now going to begin trading oil in yuan. He said the story had gone unnoticed but that it represented a significant shift in the role of the US dollar in global trade. I had responded that the yuan was making new highs vs. the USD and I had wondered whether it was indicative of fewer dollars being exported to China. However he raised a valid point. If China was going to purchase oil in yuan there would be less demand for dollars. Could this be behind the drop off in FX reserve accumulation?

As I often do, I asked my friend in the steel business about the price of iron ore. He responded that the price of scrap -- the most sensitive to global demand -- was collapsing, which I later confirmed in the aforementioned Bloomberg Businessweek article. He was no doubt on top of the price implications and seemed to prudently operate accordingly.

Was it something cyclical like the fiscal cliff or election that would soon pass, or something secular more akin to a paradigm shift that I had discussed last week? I can't be sure. We have a lot of indicators that, on their own, could be saying something different, but added together could be saying the same thing.

The consensus trade is to get long the QE asset reflation correlation, however what I am seeing is just the opposite. That big sucking sound you hear might be a precipitous drop off in the demand for money. When that happens, the price of risk assets are soon to follow.

Twitter: @exantefactor
No positions in stocks mentioned.
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