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Over the past several months, with the price of crude plummeting to half where it was compared to a year ago, we have written much about the monetary reality of the Petrodollar (and more importantly, its recent disappearance), the socioeconomic implications for oil/commodity exporters, the liquidity considerations for the those who create the "recycled" currency in question, and the resultant demand for assets created by public and private entities sold by the currency creator, in the process boosting the "value" of both the commodity, the demand for the currency (usually the world's reserve at any given moment), and the assets of the currency host.

We have explained this cycle and more importantly, what happens when this cycle goes into reverse, in "How The Petrodollar Quietly Died, And Nobody Noticed" and "The Death Of The Petrodollar Was Finally Noticed" (not to mention "Russia Just Pulled Itself Out Of The Petrodollar").

Still, the underlying concept of how Petrodollar recycling, or as some call it, petrocurrency mercantilism works, leaves some confusion. So in order to alleviate that, here courtesy of Cult State, is a quick and simple primer that should hopefully answer all questions.

From CultState:

So what is petrocurrency mercantilism?

It’s when a national bank and an energy producer collude to generate artificial demand for a currency at the expense of the purchasing power of other currencies.

The flowchart below shows how it all works.

Keep It Simple, Stupid...

ZIRP...

QE...

Welcome To The New ParaNormal!!

h/t @RudyHavenstein

While the Hillary Clinton email fiasco is sure to be the talk of the town for the next few days, weeks, and months and may have seriously jeopardized the former SecState's chances at becoming America's next president, an even more important story is how the revelation that Hillary exclusively used a private, unencrypted and unsupervised email for 4 years of state-level, official business communications, emerged in the first place.

The answer, shockingly, comes courtesy of a Romanian hacker who was known by the handle "Guccifer", and who is currently serving time in a Bucharest prison for his online attacks against countless public figures including the infamous leaks of George W. Bush personal paintings.

How is it possible that a Romanian convict may have helped accelerate the downfall of Warren Buffett's presidential hopeful? According to the Smoking Gun, which first reported on this topic back in March 2013, “Guccifer” illegally accessed the AOL e-mail account of Sidney Blumenthal, who then worked as a senior White House adviser to President Bill Clinton, and later became a senior adviser to Hillary Clinton’s 2008 presidential campaign.

When “Guccifer” (who was later identified as Marcel Lazar Lehel) breached Blumenthal’s account, he discovered an assortment of correspondence sent to Hillary Clinton at the e-mail address hdr22@clintonemail.com. The “clintonemail.com” domain was registered in 2009, shortly after her nomination to become Secretary of State.

While Blumenthal, a longtime Hillary Clinton confidant, used her private e-mail to send personal messages (like a get well note after she fell at home and suffered a concussion in December 2012), he also forwarded the Cabinet member a series of “Confidential” memos about foreign policy matters.

A snapshot of one leaked email between Blumenthal and Clinton can be seen below:

If Clinton used her own account only emails like the one above, it would be perfectly ok. It wasn't.

Using her personal clintonemail.com address, the “For: Hillary, From: Sid” memos, provided to TSG by “Guccifer,” address a wide range of topics in global flashpoints like Algeria, Turkey, Mali, and Libya. Blumenthal also provided Clinton with information about the European Central Bank, the Georgia elections, and German Chancellor Angela Merkel.

Here is a snapshot of the inbox:

All of this happened through a personal email account, using a small Jacksonville, FL shell registrar called Perfect Privacy LLC, which is owned by web.com.

A registrar in whose possessions one can now, or could at one point in the past, find "confidential" memos such as this one from January 15, 2013 on "Libya internal government discussion," which relied on “Sources with direct access to the Libyan National Government."

Among the other memos to Clinton can be found titles like “Comprehensive Intel Report on Libya,” and included all-cap warnings that, “THE FOLLOWING INFORMATION COMES FROM EXTREMELY SENSITIVE SOURCES AND SHOULD BE HANDLED WITH CARE.”

Each memo included a note on the sources of intelligence included in the document. One typical memo referred to “Sources with access to the highest levels of the Muslim Brotherhood in Egypt, the leadership of the Armed Forces, and Western Intelligence, diplomatic, and security services.”

The Smoking Gun adds that the memos offer no indication as to whether the intelligence gathered by Blumenthal was done at Clinton’s suggestion. Likewise, the hacked material does not include evidence of Clinton’s response to Blumenthal’s memos (which appear to have been prepared with input from Tyler Drumheller, a former Central Intelligence Agency official who ran covert operations in Europe).

As a reminder, this is just one hacked account - one which was corresponding with Hillary Clinton - and shows just the emails that were sent or received by Sidney Blumenthal. However, it provides a broad enough glimpse of the kind of information that Hillary was trafficking in without any US government supervision or tracking.

It also means to keep a close eye on Clintonemail.com registrar status, which is the server where one can find any and all of the tens of thousands of emails that the former first lady sent and received between 2009 and 2013 in her personal account: an account which was created on January 28, 2009 and is scheduled for expiration on January 13, 2017... unless, of course, something "IRSy" were to happen to it in th emeantime, and all existing emails and backups are mysteriously lost.

But most of all, keep a close eye on this email address: it will be topic of countless hours of discussion as America heads into the next presidential elections.

Especially since as of this moment, it appears to be disconnected.

Submitted by Lance Roberts via STA Wealth Management,

Yesterday, I discussed a few of the issues surrounding the current extension of the cyclical bull market and the excuses that will be delivered when it eventually ends. The current deviation in price from underlying economic fundamentals should be a warning sign for investors. However, when prices are trending strongly higher, warnings often fall on deaf ears. That is the nature of the investing game. 

I am traveling today and tomorrow for a presentation but I wanted to share this piece by Justin Kermond about "Luck and Skill in Investing."  Howard Marks of Oaktree Capital Management has been a voice a reason over the years and his thoughts about investing are always salient.

---

When Howard Marks graduated from the Booth School of Business of the University of Chicago, he was turned down for the one job he really wanted. That, he said, was the luckiest moment of his career. The firm that turned him down was Lehman Brothers.

Marks is the co-chairman and founder of Oaktree Capital Management. He spoke to an audience of investment professionals and MBA students at the annual MIT Sloan Investment conferencein Cambridge on February 20th.

His talk was moderated by Randy Cohen, a senior lecturer at the Sloan School. Marks and Cohen discussed a range of topics, including his luck and skill in career choices, the lack of efficacy in forecasting, the importance of second-level thinking, investing in the current interest rate environment and the ingredients for investment success.

On luck and skill in career choices

Marks said he was not the kid who started reading prospectuses at nine years old and then invested his bar mitzvah money. Before deciding on a career in finance, he considered being a history professor, an architect, an advertising man and an accountant. Before graduating from the University of Chicago, he interviewed for jobs in corporate treasury, banking, investment management, investment banking, accounting and consulting.

But he got lucky when he was turned down for the one job he was sure he wanted. Marks recounted that the recruiter had decided to hire Marks, but the partner in charge of making the final hire came in to work hung over that morning. He offered the job to the wrong guy. If it wasn’t for that piece of bad luck, he said, he could have spent the first 30 years of his career at Lehman Brothers, ultimately ending up with nothing for whatever equity stake he might have earned.

Luck is very important, according to Marks, and he advised the future MBAs to “put themselves in the way of good luck” as opportunities only come around once in a while and you have to take them.

On the lack of efficacy in forecasting

Forecasters have been very poor and consistently so, Marks said. In the summer of 2013, forecasters unanimously predicted that rates would go up after Federal Reserve Chairman Bernanke started talking about tapering. This was the most important decision in 2013 and most forecasters got it wrong as rates went down. 

The most important decision of 2014 was the price of oil; very few forecasters got that right either. Marks advised giving up on the forecasting game and taking a more humble approach to fore knowledge. When he is asked what is going to happen to the price of oil, he said, the only correct answer is, “I don’t know.” Oil is an asset that does not produce cash flow, and it has not sold at a free market price. Since it is an administered price, he knows it will be unpredictable.

While Marks warned about forecasting, he said that you can’t invest without making some judgments about the future. Marks said that Oaktree invests in the areas that are under pressure. In the last four months those areas have been oil and oil-servicing companies. “Value investors proudly invest in assets based on the discounted price of future cash flows,” he said.

Do not invest in companies where their future is heavily dependent on the price of oil, Marks warned, because it is so unpredictable. Instead, he advised investing in companies that “can survive in a broader range of outcomes because the [oil] environment is so bizarrely uncertain.”

In periods when the markets do not change dramatically, most investors get it right most of the time but it does not make them any money. It is very valuable to forecast radical changes, as in the case of oil prices, but most people don’t get this right and this makes forecasting so unavailing. When something radical happens, someone gets it right, but Marks asks himself did this person get anything else right before or after, or do they just take extreme positions? 

Marks quoted Mark Twain,

“It’s not what you don’t know that gets you in trouble but what you know for certain that just ain’t true.”

On the importance of second-level thinking

Eight years ago, Marks’ son advised him to invest in Ford because they were coming out with great new products. “Who doesn’t know that!” Marks said in response. He was not trying to denigrate his son’s enthusiasm for Ford, but to challenge him to think on a second level. The things everyone knows will not bring you an edge.

If you think the same as everybody else, you will act the same as everybody else. If you act the same as everybody else, you will perform the same as everybody else. If you want to outperform, then you have to think differently and act differently with higher level thinking.

With first-level thinking, an investor thinks that a company is great and buys the stock. With second-level thinking the investor thinks that the company is great but not as great as everyone thinks and therefore sells the stock. Marks described first-, second- and third-level thinking in the context of Maynard Keynes’ observations in predicting winners in newspaper beauty contests in London in the 1920s. With first-level thinking, you pick the winner based on your opinion. However to win the contest you need to have at least second-level thinking and pick the girl who you think will get the most votes.

Ben Hunt provided further details on Keynes’ observations of third-level thinking on his Epsilon Theory blog. Hunt stated that to win the contest you have to make a third-level decision and pick “who will get the most votes when all the voters are basing their votes on who they think will get the most votes”.

Successful investing comes from “variant perception,” Marks said, where the consensus view is incorporated into the price of the asset and you have a different view from the consensus. If your variant view is correct, then eventually the consensus comes to agree with you and the price moves favorably in your direction. Marks said if you think investing is easy and you do not see the complexities, you will not be successful.

On investing in the current interest rate environment

Since the 2008 financial crisis, you cannot get paid for safety and liquidity, according to Marks. He described himself as a “conservative guy who likes liquidity and safety.” Prior to the financial crisis of 2008 all of his money that wasn’t in Oaktree or its funds was in laddered portfolios of Treasury bonds that produced a return of 6.5%.

After the crisis, Marks asked himself why one should be able to invest money with absolute safety and liquidity and be well paid for it. Marks said that when people are “freaked out” they will pay to have their money stored safely even if they lose a little as in the current negative interest rate environment. Investors now can get safety and liquidity but they don’t get paid for it.

Although he thinks that free markets do the best possible job of allocating resources, Marks said that we are not in a free market environment and “the cost of money today is no less controlled than the cost of oil a year ago.”  He does not believe that market conditions have changed enough to warrant the interest rate reduction on the 10-year government bond from 6% eight years ago to 2% today. He said the interest rate is artificially low due to the Federal Reserve intervention, but he does not believe that conditions are bad enough or that inflation is low enough to warrant the current 2% rate. This is an artificial rate, and Marks said it is difficult to predict what the natural rate should be if it were left alone or whether it will be left alone.

On The Ingredients For Investment Success

In the short term, Marks said the ingredients for success are aggressiveness, timing and skill. He mused that if you have enough aggressiveness at the right time, you don’t need any skill.

The person who successfully predicts the decline of the price of oil or gets the highest return in a given year is lionized by The Wall Street Journal. In the short term, it is impossible to know whether this success was due to luck or skill, but it will come out in the long term because it is hard to be lucky for 20 years.

Marks went into further detail on luck and skill in describing the 2006 collapse of the hedge fund Amaranth. Marks said that Amaranth lost 90% of its assets not due to poor bets in 2006 but because of their success in 2005 when they were up 100%. He offered that “losing 100% is only the flip side of making 100% if there is no skill.” Marks said Amaranth made some “wild ass” bets in 2005 and got lucky and then made similar bets in 2006 and got unlucky.

Marks said he has been successful by not taking bets that could lose dramatically, by mitigating loss, and by being consistent rather than having brilliant successes outweighed by dismal failures.  He said, “If we avoid the losers, the winners take care of themselves.” He stressed the importance of matching your investment strategy with your personality and offered that his conservative nature supported his success in the bond market. A venture capital fund would fail if he ran it because he is “not a dreamer, a futurist or a congenital optimist.”  What he tries to do is “take ten dollars and turn it into eleven, and have it become eleven before it becomes nine.”

By Brad at www.CapitalistExploits.at

To succeed in investing you essentially have to beat the majority of other investors. This will not be achieved by thinking like everyone else. You will have to think and act differently to everyone else.

How do most people think when it comes to trading, or at least what do they spend most of their time on? The majority spend their time attempting to determine what will happen in the future? Very few think about risk and reward. That is, how much will I make if I am right versus how much will I lose if I am wrong! Yes, to succeed you must think more about payoffs of future events not the future itself.

It is this simple concept which separates great traders from merely good traders. We will come back to this concept later.

Today I want to talk about China, yet again. But this time I want to talk about the ultimate effect of the Chinese central bank’s obsession with managing its exchange rate.

As you are probably aware China manages its exchange rate by letting it trade within a band. They do this for a simple reason - to suppress currency volatility and uncertainty that comes with volatility. However, what few realize is that the act of trying to suppress volatility actually increases it – eventually. Chris recently wrote an article on how all currency pegs break. The more one tangles with market forces the greater the consequences of this action in the future. Some fantastic examples of how the asymmetry builds up can be found in our article on the topic.

When you have been involved in the markets for many years you will probably come to realize a pattern in market behaviour. Periods of low volatility are followed by periods of high volatility. This observations tie in nicely with Nassim Taleb's concept of fragility and anti-fragility: systems that appear stable and have not been subject to stress are inherently fragile. The more stress a system has been subject to the more anti-fragile it becomes.

The recent action in the Swiss franc is a perfect illustration of this concept. The EUR/CHF was, effectively, frozen in time for the better part of 3 years with the Swiss National Bank (SNB) stepping in to prevent the EUR/CHF from falling below 1.20.

EUR/CHF spot rate chart

By pegging the CHF to the euro at 1.20 the SNB put a lid on how much it would appreciate against the euro. In doing so the SNB's balance sheet grew faster than even the US Federal Reserve's balance sheet, and finally in January the SNB realized it was fighting a losing battle and threw the towel in. This resulted in an "off the Richter scale" move (+30%) in a few minutes! This disorderly revaluation shook the currency markets and impaired a number of financial institutions!

In trying to suppress volatility and create more certainty all the SNB euro pegging efforts succeeded in doing was to achieve the exact opposite!

Going back to China and its managed exchange rate – doesn't the suppression of volatility ultimately create more fragility in the Renminbi? Yes, it may appear to be very stable now with relatively little volatility but in a couple of years from now this could well be a very different story!

Now, to better understand the long term outlook for the Chinese renminbi let's first understand how currencies have fared against the USD since it bottomed out in 2011.

Below is the JP Morgan Emerging Markets Currency Index. This is a tradeable benchmark for emerging markets currency markets. It is comprised of 10 liquid currencies across three geographic regions, all equally weighted: Latin America (CLP, BRL, MXN), Central and Eastern Europe, Middle East and Africa (HUF, ZAR, RUB, TRY), and Asia (SGD, CNY, INR). It has fallen by some 30% which means that the USD has appreciated by some 30% against these currencies.

Similarly, the USD Index (below) which tracks the performance of the USD against developed market currencies has risen by some 27% since the bottom in 2011.

During this time the renminbi has appreciated by about 4%.

So what, you might say? Well, in essence Chinese exporters have become less and less competitive over the last 4 years. Given how quickly the Chinese economy is slowing (due in no small part to them losing export competitiveness). If the USD continues to appreciate Chinese exporters will continue to lose competitiveness.

Below is an index of implied volatility of long-term options on the USD/renminbi. Although volatility has increased somewhat over the last 6 months it remains very low and, by comparison, it is only a third of volatility on the Aussie dollar and euro.

Clearly the crowd still doesn't believe that a material movement in the renminbi is on the horizon. This is a dramatic mispricing and it is where opportunity knocks! I believe this trade can potentially have a much bigger payoff than the U.S subprime mortgage collapse and European crisis did.

 I see no way that the Chinese can avoid a material devaluation of their currency or face an economic recession. Or perhaps both.

When we look around the world today, virtually every central bank is engaged in aggressive monetary debasement, bringing their currencies down in value against the USD to make things look better than they are. While this may ultimately have inflationary consequences, in the meantime central bankers see absolutely no negative consequences in monetary debasement/quantitative easing - call it what you will. So they will continue doing what they are doing which will push their currencies lower and leave Chinese exporters "high and dry", unless the renminbi is allowed to materially devalue!

China's primary monetary policy tool has been to actively manage its USD/CNY exchange rate. In 2014, the game changed in China as the super easy monetary policy from the US Fed came to an end. No more QE and slowing global growth created an environment where all these foreign exchange (FX) inflows not only dried up but turned into outflows (capital flight).

As a result, China's economy is exposed to a risk it has not had to think about since 1994 – credit contraction! The Chinese authorities are aware of this and the PBOC has taken measures to ease monetary policy. They have injected liquidity into the banking system and cut rates twice in the last 6 months. So the monetary policies of the PBOC and the Fed have begun to meaningfully diverge for the first time in many years. Without another round of QE from the Fed, this divergence is almost certain to accelerate and create enormous problems for China and their currency peg.

This divergence is very important because similar divergences have been the catalysts behind the dramatic weakening of the Japanese yen and the euro against the USD over the last few years.

The Chinese have reached a crossroad, but they are in denial. Despite the rosy picture painted by official statistics, such as GDP growth, more reliable indicators of economic activity tell a much different story.

Bank of America Merrill Lynch China Leading Economic Activity Pulse Index is an index of the year-over-year changes of seven component indicators (power output, steel output, cement output, auto sales, housing starts, railway cargo turnover, and medium to long term loans).

BofA Merrill Lynch China Leading Economic Activity Pulse Index

If this index is anything to go by the 7% GDP growth that the Chinese authorities tout is a mere figment of their imagination!

China Monetary Conditions Index (below) is based on real exchange rates and total loan growth. It seems to me that monetary conditions are as tight as what they were during the height of the GFC when the world's financial system froze up!

China Monetary Conditions Index

The two graphs above suggest that the Chinese economy is in very big trouble! To prevent a collapse of China's financial system, crippling economic contraction and a destabilizing rise in unemployment, the PBOC must take more aggressive action.

Clearly the efforts of the Chinese authorities to "stimulate" their economy are not working and will not work. The historical means for providing monetary stimulus is unavailable, as net foreign exchange inflows no longer exist.

In light of this the Chinese seem to have changed the focus of their monetary policy from one that targets the exchange rate to one that targets domestic money supply growth. This shift will only serve to increase the divergence between the Fed and PBOC monetary policies and put more downward pressure on the renminbi.

Recent behaviour in the renminbi would suggest that the Chinese authorities are gradually losing control of the exchange rate. Technically, with a higher high and higher low, it would appear that the USD/CNY is getting ready for a material move to the upside.

USD/CNY spot rate chart

How high can the USD/CNY go? As discussed above, the USD has appreciated by about 30% against an equally weighted basket of currencies since 2011 with most of this move occurring during the last 6 months. However, the renminbi has appreciated by some 4% against the USD during this time. If the CNY were to only recover the amount it appreciated against other currencies since 2011 then the USD/CNY would be approximately 8.40 today (6.27 today multiplied by 1.34). That is a big move, which isn't even remotely being priced in by the market.

Does a move of this magnitude sound far fetched? Well, if you were around long enough you might remember a similar move that occurred in one day, late December 1993 (as shown on the USD/CNY spot rate chart below)!

Let's not forget the Asian financial crisis in 1997 when capital flight took hold Asian currencies didn’t just depreciate by 30% - it was multiples of that!

Note the rupiah graph below. Prior to the Asian financial crisis, the rupiah and many other Asian currencies were managed or pegged to the USD in an attempt to reduce volatility and make the future less uncertain for exporters/importers. As it turned, out all this served to do was to cause more volatility in an exponential way!

Financial systems that appear robust are more often than not inherently fragile!

USD/Indonesian rupiah spot price chart

One message from the Asian crisis is very clear: be weary of any central authority who tries to suppress currency volatility! The more a central bank tries to suppress currency volatility the greater the consequences down the track. And contrary to popular belief China is no exception!

Perhaps the payoff to buying long term calls in the USD/renminbi could well rival the returns that occurred to those wise few that had the wisdom to "short" sub-prime back in 2007/2008. Given the risk/reward payoff I think the trade is way too attractive to pass by.

- Brad

PS: Brad will be joining us at our Bullring Mastermind in beautiful New Zealand in a few weeks time. You can get more details about the event here.

"Fragility is the quality of things that are vulnerable to volatility." - Nassim Nicholas Taleb

Earlier today, we laid out all of the myriad reasons why Draghi-style QE won’t (indeed can’t) work. Some of these reasons are logistical (euro fixed income supply/demand imbalance) and some are structural (former easing efforts impeding current accommodation). We’ve also taken a hard look at the deleterious effects CB asset purchases have had on market liquidity and, by extension, price discovery, and volatility. Here, we present yet another unintended (we hope) consequence of monetization gone wild: underfunded pension plans. 

Of course anyone with a basic understanding of the time value of money could have predicted this, so we’re sure it was in the back of more than a few peoples’ minds, but apparently the situation worsened materially over the past 12 months or so as the market began to try and front run the ECB. 

Via FT: 

[S&P] blames the sharp fall in long-term bond yields ahead of the imminent start of the European Central Bank’s €60bn-per-month asset-buying programme.

Such yields determine the “discount rate” that pension funds must use to calculate the present value of their liabilities: the lower the rate, the higher the liabilities.

S&P estimates that defined-benefit scheme liabilities will have increased 11-18 per cent, equivalent to €58bn- €92bn, in 2014, driven by the sharp fall in long-term corporate bond yields and only partly offset by the fall in long-term inflation expectations.

… and more from Bloomberg: 

Among the measures S&P says companies may have to take to adjust to this new low-yield world are freezes on pensionable salaries, raising the retirement age, and closing plans to new or even to existing members.

So accommodative monetary policy, which is ostensibly supposed to stimulate aggregate demand thereby encouraging businesses to spend and hire, is now perversely causing people to work longer and preventing new employees from having access to a secure retirement. About the only thing worse (and more sadly ironic) than this would be if international loans designed to prevent insolvent eurozone countries from descending into Third World status were being repaid out of pensioners’ pockets — oh wait, that’s happening too.  

Meanwhile, commentators seem to be gradually catching up to what we’ve been saying for years. Namely, that this isn’t working. 

From BlackRock’s Peter Fisher, via Bloomberg: 

“Quantitative easing, which is supposed to push investors into riskier assets, instead is driving up prices of low-risk assets “as we’ve seen in Europe today,” 

“The Fed’s bond-buying program wasn’t much more successful.” 

“It didn’t really work here, it worked at the margin as a little chase for yield. People want to hoard the best assets”