Before I get into this article, has anyone seen the TV commercial for Interactive Brokers? I have to admit that I die laughing each time I do. It’s basically a cartoon which shows various Central Banks literally vomiting out copious amounts of paper currencies accompanied by the sound of printing presses. Absolutely hysterical!
As the Euro declines, which it no doubt will continue to do over time as the ECB printing presses go into Warp Speed, the main beneficiaries will be the Western economies. And while it’s also likely to slow the Chinese economy for now, in the longer term euro depreciation will help to serve a needed purpose there.
First, because oil is bought and sold in dollars, you might think that euro depreciation relative to the greenback will cause the cost of oil to increase in Europe. The opposite, however, appears to be true right now.
The cost of a barrel of oil was 64.54 euros at the start of trading on May 3 when the euro opened on $1.3354. But with the euro recently at $1.2638 and the price of light sweet crude falling to $75.88/bbl, oil has fallen to 60.04 euros (a 6.97% decline in just over a week).
Second, because the yuan is pegged to the dollar, it’s undergone (and will continue to undergo) an appreciation relative to the euro. This of course will make European exports more completive in China and will go a long way towards correcting the huge trade imbalances which now exist. It should also help cool Chinese inflation and its overheated economy, including its property bubble, first because exports to Europe (China’s largest export market) will slow as they become more expensive and second by making imported commodities cheaper (because they will decline in price as the dollar appreciates).
Chinese stock markets are likely to continue their decline in the medium term as the economy slows. Actually, we’ve already seen this happen; the Shang Hai composite is negative for the year and has basically fallen into a bear market. However, as Marc Faber has so astutely pointed out, Chinese stocks might actually benefit as capital is diverted from real estate investments.
As far as the U.S. is concerned, falling oil prices will greatly benefit consumer spending especially with the job market remaining extremely weak. True, the effect on exports is likely to be negative, but consumption is a much bigger contributor to overall GDP.
Significantly, falling oil prices will keep the Fed on hold longer (is there such a thing as longer than “forever”?) as inflation becomes even less of a threat than it already is. Indeed, core CPI increased by just 1.3% in the year to March and in the first 3 months of 2010, increased at a frighteningly low 0.1% annualized pace.
The longer the Fed stays on hold, the more that large commercial banks like JP Morgan Chase and Goldman Sachs, which racked up perfect quarters in their trading businesses between January and March, will continue to make easy profits. How can they lose when they can borrow at 0.25% and lend to the U.S. government at multiples higher? Even Marco Hague of TheLFB would have trouble messing up that trade (well, maybe not)!
Goldman reported that net revenue was $25 million or higher on each of the days it traded over the period, and said it made more than $100 million on 35 of those days, or more than half the time.
How can Goldman and the other banks manage this trick? The simplified version goes like this: First, they can borrow at 0.25%, which allows them to leverage up. The borrowed money is then used to buy Treasuries from the Fed at some discount (possibly something like3% to 4%) which is then sold at Par plus commission, thereby earning a spread (the same as our forex dealers make). When the time comes to buy the Treasury back, the bank offloads it to the Fed while again earning at least a commission on the repurchase (if not another spread).
Of course, they can also borrow and hold Treasuries on their own book, a trade that’s greatly helped by the steep yield curve which allows them borrow low and lend high.
Gold is likely to continue being the main beneficiary of Europe’s scheme to print. It reached an all-time high in nominal terms of $1234.15 on May 11 and tested support at the former resistance on $1226.37 which was made on Dec. 3, 2009 on May 12.
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