What Happens When It All Falls Apart?

I have written on a number of occasions about the correlation between oil and currencies. It now appears that a good number of those moves were not driven by oil speculators alone, but by some of the same speculators who were speculating against the dollar or currencies (depending on the direction) at the same time as they were speculating on oil. To clarify, when they bought oil, they bought currencies. When they sold oil, they sold currencies, in both cases with the exception of the yen. This can be seen by what has happened in the last week, with talk that there will be new oversight and regulations applied to commodity futures trading.

As soon as the news broke, oil was sold off from its high of $73.38 on June 30 to fall below $60 on July 9 for the first time since May 26. Why was it sold off? Because the speculative buyers paired down those positions that could not be justified and, in doing so, took their profits. They did this just in case there was a future investigation as to who had what size positions. The move proved without a doubt that at $73, oil had been pushed to the level purely on speculation. The fundamentals of falling demand and some of the highest refining capacity in months meant that supply should have pushed oil lower.

The interesting thing is what happened to currencies during this same period. To use the euro as the proxy, on June 30 it closed at 1.4033 and on July 9 it closed at 1.4020. Why was it not at least two to three euros lower as it would have been at this time last year when oil was sold off from its high? The reason is that this time when the speculators sold oil, they did not sell the euro at the same time because they were trying to clean up their books. The result: the correlation fell apart. The euro was sold off to some extent, but it recovered, moving in the opposite direction of the falling oil for three days as it reacted to fundamental economic news, which was positive for the currencies. This time the buyers did not run into the spec sellers as they would have at this time last year.

Does this mean that the correlation in the past was false? No it doesn't. It just means the very tight correlation we saw in the past was a result of spec buyers buying oil when they also bought the euro. This way, they made twice as much when they pushed both higher and then sold them off. The rest of the market last year had no option but to buy into the idea (or be suckered into it) or face standing in front of the momentum, which would have been very costly.

The reason I wanted to bring this to your attention is that the tight correlation is gone and most likely will not return to the point it was at, a year ago. The general direction of the moves should have some impact of either oil on the euro, or the euro on oil. The risk aversion move, for example, means that the asset classes deemed to be higher risk are sold off, and those that are thought to be safe havens benefit. This still means euros will be sold when oil is, and the only safe haven currencies are the dollar and the yen.

The reason the dollar is in this unusual position - given all the recent rhetoric, led by China, that there needs to be an alternative to the dollar as the reserve currency - is that there is no alternative to U.S. government debt when things get very bad as they did last September. The dollar becomes a de facto safe haven play because foreigners have to buy dollars to buy U.S. bonds. In the last couple of days as the markets got nervous about U.S. stock earnings releases, we seemed to be in a slow motion version of what we saw about nine months ago when the meltdown occurred. In the flight to safety, bonds, the dollar and yen strengthen, and commodities and equities are sold off. If this should continue and U.S. bond sales hold up to the kind of stellar results we saw for Wednesday's 10-year auction (arguably the best ever with a very high bid to cover ratio), this indicates to me that, despite the Chinese rhetoric about the dollar's position, they have just been trying to deflect the criticism they got at the G20 meeting about their currency manipulation. It will be interesting to see who bought those 10-year bonds in a couple of months when we get the Treasury International Capital flow data for this time period. My bet is China was a major buyer.

If the doom-saying, double dip recession brigade are right (yes, I am one of them), we will see a stronger dollar and yen and weaker commodities (including oil - cheaper gas) and bonds will rally (as long as there is plenty of appetite for the hundred billion dollars worth we push out almost every week, which does not seem to be a problem so far). This will lead to lower interest rates and cheaper mortgages.

Keep your fingers crossed. If this scenario pans out we might have two offsets to combat the cost of the Cap and Trade bill, should it pass!