The question for most
people is why the dollar is not strengthening with the upheaval in Egypt, Libya
and the Middle East situation. In the risk on/risk off world we have become used
to, surely there should have been a flight to quality (U.S. bonds) and
consequently the US$, which should have strengthened. The fact that it has not
happened is a red flag to Washington that the amount of debt the U.S. is
offering has gone beyond what global investors are comfortable with.
The
reason the euro has strengthened is due to the unwinding of the euro selling we
saw at the beginning of 2011 when the market anticipated the euro zone to run
into trouble with its debt financing this year. The year is obviously far from
over, but for now the market has bought into the "we will support the euro and
all that are in the currency" from the leaders of both Germany and France. For a
change, they took relatively quick action. We then have to add that the market
expects interest rates to rise in Europe before they rise in the U.S. as the
Europeans are more hawkish on inflation concerns than we are. The fundamental
economic news from Europe has been better than it has been from the U.S. But at
the last meeting of the European heads, their economic plan was not resolved but
put off until the March meeting. The market seems to have conveniently forgotten
this for now.
The stage was set up for the news we have seen recently
from the Middle East. Egypt was not so much a concern as far as oil production
goes as their output is minuscule. The concern was what will happen with the
relationship with Israel from the new Egyptian regime. Libya, on the other hand,
holds the ninth largest oil reserves in the world. We fear the consequences of
disrupted supply in a world where demand has pushed oil to a new normal higher
range of about $70 to $80 per barrel. The markets look at the outcome if oil
prices should stay at or around the $100 level. Whom does it affect most? The
answer, of course, is the U.S. When we consider what is happening globally, it
can be seen that in this scenario we really have returned to probably the most
"normal" market in nearly three years. I am not saying the risk on/risk off
market mentality will not return at some point, but for now fundamental
economics rule the day.
The British pound has not gained as much as the
euro because it was not a subject of the euro debt-associated sell-off. The UK
economy is struggling to track sideways and has disappointed recently on many
fronts, but it is holding at reasonably high levels suggesting it is being
helped by perceived dollar weakness rather than pound strength. The pound has
tracked in a two and a half cent range mostly just above 1.6000 for the month of
February, while the euro has risen from 1.3425 to over 1.3850 in the last two
weeks after being lower due to the debt concerns of Portugal at the beginning of
February.
The yen, on the other hand, has strengthened from about 84.00
to 81.60, where it seems to have run into some buying support during the last
three business days.
What happens from here? Saudi Arabia has said it
will increase its production to cover any oil production disruption from Libya.
For the Saudis this is a time when producing as much as they can has other
benefits. With neighbor Bahrain under pressure to change (a population made up
of about 75 percent Shiite and 25 percent Sunni) and Yemen on the southern
border also going through a challenge to its leadership (about 50 percent Shiite
and Sunni), the rumor is the Saudis need money to literally buy the royal family
(who are Sunnis) time, especially amongst the larger Shiite population that
lives in the Eastern province next to Bahrain where the oil is produced. Saudi
Arabia has the most oil reserves, of over 200 billion barrels, compared to the
U.S.' paltry 20 odd billion barrels. Any disruption to Saudi production due to
an uprising there would be catastrophic to the world's economy. The problem is
the Saudi Shiites have always felt as if they are treated like a minority, and
when political instability is possible the secular difference can become an
ignition point.
Fundamentally, I think the dollar is fairly well priced
at these levels. The Chinese yuan should be a lot stronger than it is, as we
have said in recent articles. I do not think the euro debt situation is resolved
to a point where it is not a factor. From the oil side it's good that we have
the Canadians next door with the second largest oil reserves at over 175 billion
barrels (but is not as accessible as Saudi oil) and enough natural gas to last
North America over 150 years. If there was ever a time Washington should
seriously look at our foreign oil dependency situation, it is now. The risk to
the dollar is obvious.
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