A butterfly beating its wings in the South American jungle can create a tornado on the other side of the world. The analogy is popularly used to describe that branch of mathematics known as non-linear dynamics, or chaos theory. Interestingly, a similar stream of consciousness argument can be applied to the financial markets as equities head higher and the dollar plunges inexorably and inevitably towards 1.45 against the euro, an all-time low. Stock markets are being buoyed by the rising expectation that central bankers in the UK and, eventually, the eurozone will be forced to follow the Federal Reserve’s lead and cut base rates in response to indications of a marked slow down in economic activity. The rate picture is, however, clouded by the possibility of $100 per barrel oil, a land mark event we view as highly possible as El Nino conditions in the southern Pacific help produce freezing conditions in the United States this winter. A rising oil price may produce another unanticipated result, a further undermining of the Saudi Arabian currency’s dollar peg which could add yet another lead weight to the US currency’s dive belt as Middle Eastern reserve assets look for a new home, thus bringing the greenback’s date with destiny a few fathoms closer.
The problem with “stream of consciousness” arguments is that there are always a large number of external variables which can either independently or collectively throw the whole idea off course. We seem to be going through one of those testing phases right now. Whilst it is our assumption that US economic activity will slow markedly and that the Federal Reserve’s beady eye will switch to focusing on growth from inflation, paving the way for further US base rate reductions in an attempt to engineer and upward sloping bond yield curve, there are sufficient numbers of alternative (and more optimistic) interpretations out there to pause for thought, at the very least.
Chief amongst these alternative interpretations is that the US consumer remains pretty chipper. Whilst consumer confidence levels have fallen, they have not yet plunged off a cliff, despite the now long running residential property “train wreck” and sharply higher gasoline prices. A more detailed breakdown indicates that confidence levels have been hit amongst the most vulnerable members of US society, but that a marked disparity exists between the less well off and everybody else. To some extent this is manifesting itself in poor trading performances from those retailers most exposed to this segment of the population while the rest (those still in jobs and / or those who didn’t take advantage of mortgage teasers two years ago) blithely go about their business as if nothing had ever happened. The 0.5% point Fed Funds cut may well help shore up confidence in the near-term, although it remains to be seen how long this momentum can keep consumers in the air long after their headlong, debtpowered, leap off the cliff edge?
The other obvious concern is that growth does slowdown, reducing demand for oil and related products. Not only would this eventuality stymie the oil price as futures traders ponder an assault on $100 per barrel, but it would also help to keep inflationary pressure at bay, thus providing monetary policy makers with the scope to cut base rates yet further should they so wish. Such an eventuality would, naturally, be very dollar-bearish in the near-term.
The other possible outcome for the dollar is that the US economy ends up falling between both stools and, coupled with a deep, El Nino inspired, freeze this winter the oil price does continue to rise causing the Fed to keep at least half an eye on inflation indicators. Note that El Nino conditions have resulted in severe flooding and typhoons in Asia and flooding in Africa and Europe too, creating the environment for sharply higher wheat prices (amongst other soft commodities). Whilst these conditions could be said to be the harbingers of future inflation it might be worth remembering that they also create quite a squeeze on real disposable income which may well manifest itself during Q4, the most important season for retailers’ sales. The inevitable slide in confidence would clearly undermine the US currency.
Rising oil prices exert other, far from benign, influences elsewhere too. Aside from the unfolding crisis in Burma, itself a function of a sharp and abrupt increase in fuel prices, on 26th September the Saudi Arabian central bank was forced into issuing a press comment in the wake of its latest meeting, reaffirming that country’s commitment to maintaining the dollar peg to the riyal (following a similar decision from the United Arab Emirates on the same day). Normally this news item would not feature on the global economics Richter Scale, let alone feature in our weekly publication, however, we view the oil rich Middle Eastern powers’ decision as significant, if not lasting.
The reason for this is that these countries have contributed, with China, India and Japan, to the ageing dollar support operation by which oil revenues are ploughed back into the US Treasury market in a gigantic vendor financing operation. However, the higher the oil price climbs, the more the pegged riyal exacerbates domestic inflationary pressure. Therefore we regard the Saudi (and UAE) announcement as being merely a temporary stop-gap measure intended to prevent currency speculators doing what comes naturally to them. The higher the oil price goes, the greater will be the pressure on regional monetary authorities to abandon the peg, a decision which could coincide with a significant reserve asset allocation decision away from Treasuries and into, say, Eurobonds or gold.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley