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Wednesday July 23, 2008 - 19:48:07 GMT
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Special Issue: The Crude Carry Trade – A short story!

Note:  This is today’s Currency Currents sent to subscribers.  We thought you might be interested in hearing this “story.”  If you are interested in receiving more detailed global macro views on a regular basis, we’d love to have you as a subscriber to Currency Currents.  We think you will find it a great value for just $49 per year.

Thank you.  Jack Crooks

FX Trading –  The Crude Carry Trade – A short story!
All the stuff that was supposed to be a good hiding place because of the “inevitable” inflation is heading south.  And everyone’s most hated “asset,” (not even considered and asset by some which is a good indication we may be approaching a sentiment extreme), the dollar, is heading north.  

Maybe it is just knee-jerk optimism over yet another rescue package from our Heroes on the Hill that will once and for all solve the credit crisis.  But as we suggested yesterday, maybe it’s something entirely different than that.  Here is a short story for you to dwell on, or dismiss completely out of hand.  No doubt it is still fiction, but stranger things have happened in the world of finance. 

Not too long ago, we wrote in Currency Currents that it was interesting that the crude oil - US$ correlation was becoming a bit less correlated.  And though correlations have a way of ebbing and flowing, it was odd that crude oil blew off to a high of $150 per barrel and the dollar didn’t make a new all-time low.  In fact, the all-time low (measured by the US$ index) came when crude oil was around $104 per barrel (dirt cheap in retrospect—LOL!).


Crude Oil vs. US$ Index Daily:  The US$ made an all-time low when crude was hovering around $104 per barrel.  Thus, a 44% increase in crude and the dollar actually rallied slightly.

 (Chart unavailable in text format.)

So, despite another $46 dollar blow-off move in oil, the US dollar continued to hover above its low (which incidentally was made on the same day Bear Stearns was “saved”).  Net-net, either:

1) Oil producers aren’t running from the dollar like they were.  Maybe they were urged to believe a bottom is near (and it may be thanks to consecutive visits, and carrot and stick schmoosing, by V.P. Cheney, President Bush, and Treasury Secretary Paulson, as we noted in a Currency Currents recently, who made consecutive trips to the region beginning in March).
2) It is a correlation—and correlations are by their very nature can be nebulous and useless at times, especially over short-term time frames.
3) Falling global demand is leading to a closing of the Crude Carry Trade.  Say what?  Yes, it is a theme we’ve been working on/thinking about/conjecturing or guessing about…and it goes like this:
a. Country X, a non-oil producer, needs to import crude oil, which is invoiced in US dollars.
b. Country X notices the dollar price of crude rising and the dollar falling, so decides to borrow dollars to buy crude.  And over time Country X notices that paying back those dollar loans is getting cheaper and cheaper.  So, why not continue to make this trade, using less of government of Country X budget to buy crude directly, why not just keep borrowing more dollars? 
c. Now this is the tricky part that we have been “thinking about, but can’t confirm with hard numbers,”…
i. Two things are changing that lead to a closing, or reversing, of the crude-carry trade:
1. The credit crunch i.e. access to available credit is making it harder to borrow dollars, and
2. Falling domestic demand for energy, because of slowing growth in Country X, means there is less oil needed to support the economy.
a. Thus, the need/ability to borrow dollars to pay for crude declines.  And as this pressure is relieved, the dollar stabilizes and even rises relative to Country X currency, especially if Country X is of the emerging/developing nation variety where central banks are way behind the inflation curve. 

This is a classic self-reinforcing process…lack of global credit leads to slowing global growth, leads to slowing oil demand, leads to more closing of the Crude Carry Trade, leads to change in dollar sentiment, leads to new price trend led buys short-term players, and leads to capitulation to the trend on the part of dollar perma-bears…

And thus, the little whisper of “the dollar is nearing a bottom” softly into the ears of Gulf States leaders by the Bush administration pays big dividends to a world that is desperately in need of its defacto central bank (the US Fed) gaining a modicum of credibility in the form of value flowing  

And with crude falling and the dollar rising, a little allocation from oil producers back into dollars starts to make some financial sense—adding increasing reinforcement.  

This story is still fiction.  But the premise, we think, makes sense.  The probabilities—we can’t begin to guess.  But as I said before, thinking about alternative themes and staying open to the market information flow is the best we can do to help position ourselves for the next big move, no matter what we trade. 

And here at the Agora Financial Symposium in Vancouver, I’ve yet to hear one person say anything good about the dollar.  All I can say is: “Don’t hate!  There is still a chance we can avoid Banana Republic Land after all.” 


Jack Crooks
Black Swan Capital LLC


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