The velocity of Gold and the end of the petrodollar
Next Monday, March 26, China’s new oil futures contract launches.
This could have giant macroeconomic repercussions. I want to briefly outline the common ideas about these repercussions, and suggest a contrarian view.
To me, macro-economic issues like this are entertaining, like a puzzle. It’s interesting to try to put the pieces together, and guess what will happen, or even understand what is happening, or has happened.
In 1971 the US went off the gold standard, and on to the oil standard. Since 1971, all world transactions in crude have taken place in dollars, an arrangement known as the “petrodollar.”
Since 1971, the dollar has not been backed by gold, but arguably by oil (and actually by debt and the American economy to keep paying that debt.)
When China, or whoever, buys oil using the new futures contract, they can buy it with Chinese Yuan, instead of US dollars.
Then, since most crude vendors probably don’t want yuan, China has then set up a mechanism through which yuan can be traded for gold.
So in some sense, this resurrects the gold standard, in the yuan. Although, I don’t know if the value of gold is fixed in yuan, like the dollar once was (when gold was $20 per ounce for a long time.)
Gold bugs believe China’s futures contract will reestablish the gold standard, monetize gold, and make the value of gold go to the moon. And conversely, they think the dollar will crash and burn.
And maybe they are right. But what if they’re not? Why wouldn’t they be?
Most people think the value of a currency is based on demand for that currency. Greater demand = more value. I have argued this point with people.
My idea is that the value of a currency is based on the money supply, the quantity of that currency. Less quantity = greater value. The Fed calls the quantity of dollars M2.
This is a simple thought experiment. If there were 1000 total dollars in the world, and everything was priced in dollars, then you printed 1000 new dollars, doubling the money supply to 2000 total dollars, prices would fall in half, right?
Velocity of money
But it’s not that simple, it might be argued. True. There is another factor, which is the velocity of money. The more times a dollar changes hands, the more it’s “velocity.”
In our 1000 dollar world, if the economy picks up, and the transactions double, it has the same effect as adding another 1000 to the money supply. Higher velocity = lower value.
The velocity of money can be measured, and here is a dynamic chart of the velocity of dollars:
As you can see from that chart, the velocity of money has been falling since peaking in 1997, which is something we can ponder later.
Velocity of gold
To present my simpleton idea simply, without exhaustive analysis:
For the last 50 years or so, gold has had little velocity. People buy it, and stick it in a vault, and it just sits there.
If the Chinese oil futures product re-monetizes gold, increasing its use, transactions, and therefore velocity, could it counter-intuitively decrease the value of gold, relative to dollars and other currencies?
If the dollar velocity falls, when gold replaces dollars in many global oil transactions, could that create the effect of a shrinking money supply, so that the dollar rises in value, as it falls from favor?
Yes, this is probably the end of the dollar as the world reserve currency. But it’s probably not the end of the dollar.
Did the British pound cease to exist when the dollar replaced it as the world reserve currency around 1940? No, and the pound is a strong currency, relative to dollars.
Sentiment and fundamentals
If more people want an asset, the price rises. Markets are an auction, and as people outbid each other, price rises.
This is the principle behind the common gold bug idea that the China oil futures contract would make gold go up, and the dollar go down (more people want gold, less people want dollars.)
But currencies are not assets, and don’t act like assets, fundamentally. (You buy an asset as an investment to hold….you only want units of a currency to spend…currencies are not a store of value, like assets.) But sentimentally I would think currencies could temporarily act like assets.
The idea of “efficient markets” is that collectively, a large group of people making a market, collectively constantly price everything exactly right.
Trading and investing is based on inefficiencies in the market. If we can find an underpriced asset, and buy it cheap, we can later sell it for a profit, when the market realizes its mistake.
Since Jan 1 2017, the dollar has been in steady decline. Why? The Fed stopped printing money in 2014…so we’re not increasing the money supply in that way. Shouldn’t the dollar be going up, not down?
Could it be that people are dumping the dollar because they have the gold bug idea? That it’s a sentimental market inefficiency (or efficiency, if they’re right)? It has taken China years to create this oil futures contract, so it has been telegraphed for a long time.
A crowded trade is when people, the market, overwhelmingly thinks the same thing. Currently, the dollar short (thinking the dollar will keep falling, is a crowded trade.) Everyone thinks that. Conversely, the dollar long is an “empty” trade.
Crowded trades can lead to violent reversals, if the market suddenly realizes it was wrong. Because, as price reverses, it moves not only from new buyers, but from shorts covering, a “short squeeze.” (Or long liquidation, if the crowded trade was long.)
Of course, a currency value not just about the velocity and quantity, but those things relative to the velocity and quantity of other currencies.
And to add to the complexity of the system, dollars or euros or yuan or whatever, in a debt based monetary system, are “printed” or created, not just when central banks print them, or governments borrow them in to existence, but any time debt is created…so therefore, when corporations create and sell bonds, when people borrow to buy a house, or a car, or go to college.
So the fundamental value of a currency is a complex of how much money is being added to or subtracted from the system (money is subtracted when debts default, or get paid off), how fast that money is moving, and these things relative to other currencies.
Throw in the potential sentimental market inefficiency of people trading a currency like an asset, and together with fundamentals, you get the squiggles on a chart of historical value.
Technical trading or investing involves looking at price historically. And when prices return to levels where values were established in the past, the market compares the new situation to what it was in the past, and reacts in characteristic ways.
On a 20 year chart of the dollar, the dollar spent most of the last 20 years from $70-90. In 2015, it broke out of this range (when the Fed stopped the printing presses, and therefore stopped adding to the money supply, thereby increasing the value of the dollar.)
Technically speaking this area acts as resistance. It would be hard for price to fall quickly through this area. It is more likely to use the historical prices as a base, and bounce away from it, at least at first. If price is going lower, it’s likely to be a grind, not a quick slide.
Also noteworthy, this chart says as much about the Euro as the dollar, since the dollar value is established by comparing the dollar to other currencies. But it is heavily weighted towards the Euro, which makes up over 50% of the basket of currencies against which they dollar is compared.
$ debt appetite
The other part of the gold bug argument is that the Chinese oil contract will cause huge disruptions in the US economy.
The argument is that US expansion has been fueled by the petrodollar, by insuring the world demand for dollars, and therefore the global appetite for US treasuries, and perhaps other forms of US debt.
The US has expanded for decades by borrowing. But what if the world decides we are a bad credit risk, and we can’t sell bonds to the Chinese or the public or whoever?
Would this really be the result of the dollar losing its status as a reserve currency? Maybe.
How would the contrarian argument work here?
If my idea about slowing velocity leading to an increasingly valuable dollar were true, and you held bonds in dollars, paying out interest in dollars, and finally redeemable for dollars, after 5 years, or 10 years, or 30, and you thought the value of dollars was increasing…