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A Return to Parity?


Euro not without its problems.


Last week I wrote that we could see a drop in the price of oil as speculators seemed to be storing it in very large tankers and "slow steaming" them to port in a bet that prices would rise. When everyone is on the same side of the trade, the time is right for a reversal. This is especially true when there's a large potential supply sitting on the sidelines.

This week I'll briefly look at this prediction and perhaps even more ominous problems for commodities in general, at least in the short run. Then I'll turn my attention to the euro.

First off, oil dropped about 4% yesterday and is down almost $10 from its high only a week ago. Yet supplies of crude oil surprisingly dropped by 8.8 million barrels yesterday. Oil shot up on the news as both those who were short covered their bets and even more people piled into the long side of the trade.

But then the EIA report gave the rest of the story. It seems the shortfall "was due to temporary delays in crude oil tanker off-loadings on the Gulf Coast." And as Dennis Gartman noted this morning, "officials at the Louisiana Offshore Oil Port (LOOP) said that some crude oil tankers cancelled scheduled deliveries last week." The owners of the oil in those tankers are now down about 6-7%, whether it's speculators in the pits or the actual trading companies.

I talked with George Friedman of Stratfor this morning, and he says that the supply of tankers is even tighter, which suggests there's even more oil on the seas looking for a home. Crude oil prices could be under pressure in the next few weeks and months as whoever holds that oil is going to want to get it onshore somewhere and out of very expensive tankers.

Swapping out Commodities

The Commodity Futures Trading Commission announced yesterday that it's looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits. For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a "swap" for a specific commodity like corn and then hedge its position in the futures markets. There's no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that's traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.

The key word in the announcement yesterday was the word "classification." Right now the banks are classified as hedgers and as such have no limits. They're not really hedging the actual physical commodity as a farmer or General Mills (GIS) might do, but the hedge is their financial position.

If the CFTC decides to look through them to the funds, and it did use the word transparency in its announcement, it could decide to change the classification of the banks from hedgers to speculators. While I don't think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.

For what it's worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they're getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it's but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The writing is on he wall.

Does this mean I'm not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It's just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it's a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.

The Euro at Par with the Dollar

About five years ago, I said that the euro, which was trading at about $0.88 at the time would rise to $1.50 and then fall back to $1 over the course of a decade or more. It would be one huge round trip. By the way, giving credit where credit is due, that opinion was crystallized over a long dinner with bond expert Lord Alex Bridport and several companions in Geneva. The logic was compelling then and it still is now. We're halfway through that decade-long trip and it remains to be seen if we get back to parity. I think we will.

Why would the euro fall? Because the currency is still an experiment in cooperation. At some point, one or more of the weaker European countries is going to need more monetary stimulation than the majority of the countries in the union, for a variety of reasons. Will they pull out to be able to issue their own fiat currency? Will the EU as a whole slow down as the US recovers?

About four times a year, I give myself permission to not write a letter, taking a little mental vacation. This week, Louis Gave is graciously allowing me to use a chapter from his latest book, A Roadmap for Troubled Times which highlights some of the problems the euro is going to face, as well as analysis on a host of topics.

Gentle reader, this is an important topic and Louis says it better than I can. I highly recommend you get the book and read it. It's only about 200 pages and is a very easy read. The chapters on China are worth the price of admission, as well as his suggested investment themes. You can order the book at

So, without further ado, let's jump into the problem with the Euro.

The Change In Policy

The Divergence in European Spreads - Why Now?

Back in May 2007, I wrote a piece entitled "Part 2-So What Should We Worry About". In that ad hoc comment, I wrote:

"The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro; b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world; c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption; d) in the US, the subsidy has by and large been captured by individual consumers; e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed; f) we see little reason why, in the near future, the subsidy should be removed; but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world); while h) Europe could go through a debt crisis (far more problematic)."

It went on to say:

"Last week, and against most observers' expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country's inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank's apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.

This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.

One could argue that a change in monetary policy in Asia could end up being a "triple whammy" for Western economies. It would mean that:

  • Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
  • Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
  • As Asian exchange rates start to move higher, Asia's private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US."

Finally, I concluded the paper by saying:

"As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about "excess leverage" in the system, or the threat of a "private equity bubble". We also do not fear an "economic meltdown" or a brutal end to the "Yen carry-trade" (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities-a hedge against rising real rates-makes sense to us; as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever."

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