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Dollar Stands Firm in Wake of Mideast Jolts

By    |   Tuesday, 22 February 2011 08:49 AM

Two Iranian naval ships entered the Suez Canal and were heading towards the Mediterranean.

The IEA’s chief economist, Fatih Birol, stated that industrialized countries would consider a coordinated release of oil from stocks to meet any supply disruption stemming from the political turmoil in the Middle East.

Colonel Moammar Gadhafi appeared on Libyan state television and said: “It’s just to prove that I am in Tripoli and not in Venezuela and to deny television reports, those dogs.”

The Arab League will hold an emergency meeting of ambassadors in Cairo to discuss the situation in Libya.

Besides all that and much more, Moody's cut Japan's Aa2 sovereign rating outlook to negative and warned that it may cut the rating if government policies fall short of a comprehensive tax reform needed to bring public debt under control.

In China, Chen Jiping, deputy secretary general of the Communist Party's Political and Legal Affairs Committee, said: “The schemes of some hostile Western forces attempting to Western and split us are intensifying, and they are waving the banner of defending rights to meddle in domestic conflicts and maliciously create all kinds of incidents.”

He added: “Our country is in a period of magnified conflicts within the populace, high crime rates and complex struggle against foes, and these features are most unlikely to change any time soon.”

About the U.S., Moody's stated that President Barack Obama's budget proposal would be “marginally positive” for U.S. credit ratings in the short term, but there is “almost no chance” that Congress will pass the plan as it was presented.

So, let’s now go back to the markets. It’s not unreasonable to suppose that the net impact of recent events in the Middle East and North Africa, particularly in Libya, could provoke a significant shift in investor’s sentiment, which should translate in a net retreat from “risk.”

Looking back at what history has taught us about of the past three Middle East oil shocks, which were the “1973 Oil Embargo,” the “Iranian 1978/1980 revolution” and the crisis that provoked Iraq when it invaded Kuwait on August 2, 1990, it seems to me that we now have some, not all, of the necessary catalysts falling in place that should make the dollar one of the beneficiaries, together with the Canadian dollar.

Last week, I argued that USD/CAD’s close (inverse) correlation with the price of oil (89 percent since the turn of the Millennium) should be kept in mind should political uncertainty across North Africa and the Middle East continue to underpin the risk premium attached to oil.

Keep in mind that the Canadian dollar’s performance during the OPEC oil embargo of 1973/74 gained 5 percent against the dollar, which itself had gained 16 percent on a trade-weighted index through to January 1974.

For now, we see that the dollar has so far only enjoyed the most modest of recoveries on the back of recent events. The question investors could ask themselves now is “Why?”

As we have experienced since 1973, it is probable that a lot of people still think that the U.S. as well as the dollar may be poorly positioned to withstand a new oil shock because of the serious inflationary impact such an event could cause and therefore the dollar should come under further downward pressure, a perception that is amplified by the continued “accommodative monetary policy” of the Fed.

I would like to say that the force of such an argument is factually lessened because the eurozone is in no better position at all to weather the current developing oil price shock than the U.S. Not only are the eurozone’s and, by the way, Japan’s per capita imports of oil are not that far short of those of the U.S. but also we should not overlook that more than 60 percent of Libya’s overall exports go to Europe while only a little bit more than 5 percent end up in the U.S.

Until yesterday, both emerging and developed equity markets have shown a surprising degree of calm in the face of a potentially sustained energy price crunch and have clearly negated the idea that the markets could see a broad retreat from “risk.” It’s also worth to take notice of, and notwithstanding the price of gold has moved sharply higher over the course of the past week, especially when tracked, for example, in Australian dollars, this is hardly the most unambiguous of signals.

Nevertheless, it is also worth recalling that the price of gold fell through both the “1973 oil embargo” crisis and, after an initial spike, during the period of the Iraqi occupation of Kuwait.

Maybe a simpler answer could be that up and until yesterday investors either hadn’t been really focused in depth on events in the Middle East and North Africa or found it too difficult to calculate the broader implications of the events in Tunisia and Egypt.

In this context, it’s interesting to remember that until the middle of last week oil prices generally remained well offered, maybe because Saudi’s output in December reached a two-year high together with rising stocks in December and while its spare capacity remained at 4 million barrels per day. So, a lot of people still probably think that in case Libyan production were to dry up completely, its 1.5 million per day would easily be covered by the Saudi surplus capacity.

Well, here I must say that this way of thinking is a little beside the point. The key issue to be taken into account is the speed and uncertain path of political change that is currently working its way through the Arab world and, yes, even beyond, but that’s a subject for later.

It’s now reality that what was only a few weeks ago considered as an “unthinkable” event, today we have to face the reality that two potential Arab leaders, Ben Ali and Mubarak, who have been in power for the vast majority of most people’s working lifetimes are definitively “out” while the third one, Gadhafi, may be well on his irrevocable way out.

If all that wasn’t enough so far, now it’s also worth noting that Iran “coincidently” did feel confident enough to send a frigate and a supply ship through the Suez Canal bound for the Mediterranean Sea for the first time since the Iranian revolution in 1979. A good question for everybody could be “Why now?”

I don’t think it’s an overstatement to say that that political risk is already skyrocketing, and this will have its consequences on investors’ perception of “risk,” no doubt about that. And if all this isn’t complicated enough to understand, just look at the Reuters story from yesterday highlighting that the political turmoil in Libya could lead to separatists, yes you read well “separatists,” in the oil-rich east of Libya targeting infrastructure and looking for a bigger slice of energy revenues.

Little wonder then that oil prices have finally started to move sharply higher and Brent crude, which represents two thirds of all crude in the world, as well as West Texas Intermediate (WTI) are now about 10 percent higher than where they were in the middle of last week.

We must admit that it all has been and will continue to be extremely difficult for investors to grasp the implications for the underlying asset markets.

It’s also a fact that the currency markets have not yet fully responded to the developing turmoil in the Arab world and its associated rise in political risk. Indeed, keep in mind that in recent times the currency markets have often shined by lagging behind when reacting to sudden shifts in environment as happened, for example, in January 2010 the euro needed more than a week to finally react to when Juergen Stark, member of the Executive Board of the European Central Bank, stated “no bailout” while it also tellingly took about the same time in the summer of 2008 for the currency markets to respond to the sharp turnaround in the fortunes of oil.

Yes, and this is my personal opinion, but if I’m right, then I think that today’s strengthening of the dollar may be the first indication that the currency markets are waking up and are starting to react to the unfolding political events in the Arab world.

The fact that gold, silver, platinum, copper, palladium, etc. are down, so far of course, may well be sending the same signal from a different market. As always, we will have to wait and see.

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Two Iranian naval ships entered the Suez Canal and were heading towards the Mediterranean. The IEA s chief economist, Fatih Birol, stated that industrialized countries would consider a coordinated release of oil from stocks to meet any supply disruption stemming from the...
Tuesday, 22 February 2011 08:49 AM
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