Luke Gromen authors Forest for the Trees, an economic letter geared towards financial services professionals that discusses developing macro-economic themes… In this exclusive Sprott’s Thoughts guest essay, Luke lays out why he calls the Petrodollar a ‘broken’ system.”
By Luke Gromen, author, Forest for the Trees newsletter
Where does capital really come from?
Most US policymakers believe that capital comes from debt issued by the Fed and its member banks; most other big debtor countries agree (i.e. Japan). On the other hand, policymakers of the world’s biggest creditor nations (led by China) believe that real capital is the surplus produced from production and trade (which has been mainly accumulated in US dollars and ultimately backs the US dollar as the primary reserve currency).
For the past 7-12 years the two conflicting ideas about capital have begun to have noticeable effects in certain global asset markets. The chart below, showing gold, oil, and Fed Funds rates, illustrates what has occurred. For most of the three decades from 1973-2002, these asset classes traded closely together; in the last decade, they have been diverging dramatically. We’ll explain why this happened and the critical implications it holds for the USD prices of oil and gold.
Under the “Petrodollar arrangement,” key oil exporters promised to only price oil in USDand US interest rates were then managed so that oil exporters were indifferent to whether they stored currency reserves earned from oil exports in US Treasuries or in gold (which had always settled oil prior to 1971 via a gold-backed USD and, prior to that, gold-backed sterling).
At the time, the US was the world’s largest trading nation and oil producer. The Fed consistently managed Fed Funds rates to keep oil prices steady, even when it required mid-teens interest rates and back-to-back recessions in 1980-1982. Since US Fed Funds rates were managed to preserve US creditors’ and oil exporters’ purchasing power in oil terms, the system proved acceptable to most nations.
While the Petrodollar arrangement worked well for nearly thirty years, the arrangement began to wobble beginning around 2002-04, due to a unique combination of factors:
- The US economy had become increasingly ‘financialized’ from 1981-2000 – the percentage of US GDP derived from sectors such as finance and real estate had risen significantly. This was driven by steadily falling interest rates from the early 1980’s onwards and financial innovations such as securitization of consumer and commercial loans. This meant that cheap credit became more important to the US economy than cheap oil. This led to both a significant increase in US aggregate indebtedness and a rise in employment levels for jobs in origination, servicing, and managing credit products in the US.
- Rapid economic expansion and oil consumption growth in Emerging Markets, combined with stagnant supplies from global oil fields, drove the price of oil higher. Emerging Markets were on their way to becoming the biggest consumers of oil (and share of global GDP) for the first time ever.
Oil prices began steadily rising in 2002 and 2003 while Fed Funds rates remained low to mitigate the fallout from the 2001 US recession/Tech Bubble. As a result, the number of barrels of oil that could be purchased for a face-value US Treasury bond declined sharply.
In the chart below, you can see that in 2004, face value US Treasuries “broke support” to new 20-year lows versus oil. The dollar was collapsing against oil, likely to the chagrin of oil exporters (and US creditors like China that needed oil imports) holding US Treasuries from years of exports to the US.
After maintaining a range of 55-60 barrels of oil per US Treasury from 1986-1999, a $1,000 face value US Treasury went from buying 60 barrels of oil in 1999 to under 30 by early 2004.
This threatened the Petrodollar system. Since US Treasuries were collapsing versus oil prices oil exporters might eventually be better off leaving oil in the ground. This forced US policymakers into an important decision:
- Raise US Fed Funds rates to strengthen the dollar relative to oil, thereby supporting the Petrodollar system, or;
- Allow the Petrodollar system to fall apart.
The US decided to go with the first option; in June 2004 the Fed began raising rates slowly. This was bad for the US housing market, which had become dependent on a variety of highly-levered mortgage products that were often tied to Fed Funds rates. The housing market began to weaken as rates rose and after only 12 months and a 4.25% rise in interest rates the housing market peaked in 3Q05 and then began to weaken notably.
It was a critical but little-appreciated moment in US economic history. The US economy had now become too ‘financialized’ to withstand anything more than token interest rate hikes.
The US economy limped along in 2006 and early 2007 until collateral damage from falling home prices began to spread into the broader financial system, first through subprime loan defaults, then into more traditional lending markets. It wasn’t long before the global banking system was affected, along with other levered institutions like AIG. To prevent big banks and financial institutions from going under, the US Fed first slashed rates to near 0% and then expanded its balance sheet 5 times in 5 years to an unprecedented $4.5 trillion. While these moves “saved the system” from systemic collapse, they came at a significant cost:
US policymakers and pundits took 2007-08 to mean that the US could never default on its debt because the Fed could always print money to pay back debts that are denominated in US dollars.
Oil exporters (and other US creditors) took a very different lesson from the crisis: The US economy had now become so dependent on low interest rates that it could never again manage its interest rates to keep oil prices steady without blowing up the global financial system. The Petrodollar system, which had allowed the US dollar to supplant gold as the backing for the oil trade from 1973-2002, was irrevocably broken.
Understandably, creditor nation policymakers did not find lending money to the US at near 0% to buy real goods and, most importantly, oil from creditor nations particularly attractive. That arrangement would be akin to a land lord lending to her renters cash at 0% interest to pay their rent.
So as the Fed expanded its balance sheet 5.5 times from 2009 to 2013, creditor nations deployed significant amounts of capital into a variety of real assets including physical gold. Why physical gold and not gold futures?
Another lesson that the creditor nations learned from 2007-08 was that any highly-levered US financial market (like gold futures markets) is ultimately a general obligation of the US government and US Fed and will, if necessary, be paid out in cash.
After concluding that US policymakers could never again manage the relationship of Fed Funds rates to oil prices, creditor nation policymakers began reverting to the oil settlement asset that had been used for decades before the Petrodollar - physical gold. Physical gold collateral was removed from the western bullion banking system, leading to the sharp drop in gold futures prices seen in 2013.
What does this mean for gold and oil prices going forward? It’s likely quite bullish for both. Gold could be returning to the global financial system as a means of settlement, which could ultimately drive physical gold prices significantly higher through higher demand. The price of US oil imports would likely increase if the dollar loses its 41-year monopoly in settling oil trades. This would provide an incentive for increased North American oil production and benefit companies involved in the domestic energy services sector and related manufacturing industries.
The rollout of yuan-denominated physical gold trading in the Shanghai Free Trade Zone is set to begin September 291, followed by the rollout of yuan-denominated oil (and other commodities) expected before year end. The pricing of oil in yuan and ability to settle that trade in physical gold also priced in yuan may prove to be a critical milestone for the return of physical gold for settling international trade.
Luke Gromen, CFA is founder and editor of “Forest for the Trees”, a macroeconomic and thematic newsletter service for institutional investors and high net worth individuals.
Please see www.FFTT-LLC.com for more information.
1The Wall Street Journal online: Shanghai Gold Exchange to Launch International Board on Sept. 29