It looks like the ‘don’t trust the dollar’ crowd have switched from Crypto to Gold, which is going up as the others go down., but there are other forces at play. Crypto is a challenge to both monetary and fiscal policy makers everywhere and the evidence is building that they mean to retain control of their policy tools. The Blockchain will prosper but crypto speculators will not. Meanwhile, the debate remains open on whether reflation will develop into secular inflation and we note that supply response will be key. This may also be behind some of the more aggressive geo-politics appearing to be reversing – notably removing sanctions in the energy space, Nordstream 2 and Iran oil – although it is also suggesting to us that regardless of the dollar’s trade weighted level, the concept of maintaining energy payments in $ and thus preserving the Petro Dollar has become more urgent.

Short Term Uncertainty

The dominant ‘news’ story of the last week was undoubtedly ‘Crypto’, which lurched sharply down before meeting some support, but the reversal will likely have changed perceptions among the retail fanbase. Suddenly being confronted by the prospect of a ‘loss’, many speculators are likely to be cashing in their coins, especially as many of them have also lost money in the frothier end of the tech market and are facing margin calls – crypto being their ‘cash reserves’.

The chart shows Tesla as a poster child of the Reddit crowd and also because of Elon Musk’s influence on Bitcoin and other crypto. It also shows, the Dollar trade weighted index as well as a ratio of Bitcoin to Gold. Remember Tesla had seemingly burst its bubble back in February, but then staged a strong rally of almost 30% (big for a megacap, if modest by Tesla’s recent standards) before peaking in early April and is just about holding its previous lows around 560. Similarly, the $ trade weighted index is just above its year low having had a recent renewed bout of weakness. Finally, as discussed earlier this month, it looks like gold is benefitting from some rotation out of Crypto, as well as likely some long term buying on weakness by investors looking to hedge the $ exposure but not yet ready for Crypto.

Chart 1. Dollar, Tesla and Crypto. Three Strikes and You’re out

As we can see, its not been a good few weeks for some of the retail ‘stars’ of 2020. The $ index appears to be challenging its previous lows as Gold (a 2020 loser overall) rallies – both against the $ itself, but also against Bitcoin, seen by many as the ‘answer’ for those worried about dollar debasement arising from too much money printing and Modern Monetary Theory (MMT, a.k.a. the Magic Money Tree). As recently discussed, we suspect that some of the profit in Bitcoin and other crypto is now being ‘banked’ back into Gold, or at least diversified, while some of the recent sharp selloff is probably classic retail ‘panic’. However, we also suspect that there are other forces at work too. Much as the retail sector likes the idea of Crypto, the monetary authorities do not and the fiscal authorities even less. Both arms of government are thus keen to co-opt digital currencies to their own end via digital sovereign ‘coin’. Both sides of the political debate too, China has already launched a digital Yuan and it was China who was reportedly talking down bitcoin last week, even as President Biden talked of Crypto as being a haven for money launderers and tax evaders. Meanwhile, the announcements by both Elon Musk and the Pope that Bitcoin is “bad for the environment” suggests that the forces of global government are gathering to replace independent Crypto with sovereign digital currency. The threat to the Banking sector from digital currency remains intact, but the threat to government revenue and control will be neutralised.

Governments are showing their resistance to giving up control over currency

Medium Term Risks

A crypto crunch aside, the biggest medium term risk remains the inflation/reflation trade, with the former affecting asset allocation more than the latter, which is more about winners and losers within the equity markets. In our view it is too early to tell if we really have secular inflation arriving – certainly there are different pressures now that government appears to have a free rein on spending, but the evidence we are currently seeing is simply a short term supply/demand imbalance. The supply response is key and in the meantime, those helping to facilitate the supply response will likely prosper. This is a classic Cyclical stocks response and rotation to shorter duration assets remains the ‘obvious’ strategy here.We have already looked at some of the more obvious areas such as the ETFs PICK and WOOD that respectively invest in the beneficiaries of metals and timber, but there is also the area of Oil Services to consider. As the old saying goes, the best cure for $100 Oil, is…..$100 Oil, for it brings forth the supply needed to bring prices back down. Chart 2 shows how, the Oil service sector has already responded strongly since the cyclical rotation began at the back end of 2020, but this recent pause may present a buying opportunity for those, literally, wishing to buy into the reflation if not inflation theme.

Chart 2. Oil Services a ‘cure’ for higher oil prices?

As ever, we are not making an investment recommendation here in highlighting the Invesco ETF PXJ US, but rather we have shown it as opposed to any of the others out there mainly because it is more evenly weighted than those simply tracking the Oil Services Index, which has the issue of being very heavily weighted to a single stock – Schlumberger. At over 20% of the index this represents a high level of idiosyncratic risk in our opinion, something that remains an issue with relatively narrow ‘themes’, you achieve some diversification of stock specific risk, but not always as much as you may think. (Full disclosure, we do own the ETF).

Longer Term Trends

If Oil service and offshore drilling are one supply response to higher Oil prices, then so is the easing of other supply restrictions, notably US sanctions on Iranian Oil exports. Under the previous US administration, such sanctions on Iran did suppress oil prices for a while and certainly hit revenues for two of the USA’s geo-political enemies, Russia and Iran. However, by contrast, they benefitted a third, China, who was able to get access to cheap Iranian oil – and more importantly pay for it in Yuan – while ‘allies’ such as Europe and Japan simply saw higher prices. Similarly, the repeated attempts to stop the Nordstream 2 pipeline between Russia and Germany, seen by some as ‘harming’ Russia (and thus in their geo-political viewpoint a ‘good’ thing) in fact did far more harm to Germany. The benefit to Russia is in avoiding the official (and unofficial) transit costs of a pipeline through the Ukraine, but Russia can just as easily sell their gas to China (yes them again) in Yuan. The real winner with the pipeline is the German energy consumer, already hit badly by the decision to scrap nuclear and the increasingly high cost of green energy.

Thus to the extent that higher energy costs emerging from sanctions are harming US allies while ironically helping their geo-political rivals, it seems there may be a lifting of some of the artificial/political restrictions on energy supply. There is likely another motive too, which is the need to maintain the role of the PetroDollar and by extension the status of the US$ as the only Reserve Currency. Sanctions that encourage producers of Russian gas or Iranian Oil to trade in Euros or Yuan (especially the digital versions) undermine the $ reserve currency status and also the $ trading system, which allows the US to enforce its foreign policies on anyone with a US bank license. It is rather like allowing an alternative Apple Ecosystem to rival the then near monopoly of Microsoft, good for the consumer perhaps, but definitely bad for the monopolist.

In 1971, after the Nixon Shock, when the US abandoned the Gold window, the subsequent devaluation was characterised by the statement from Treasury Secretary William Connally as being a case of “Our currency, your problem” and this period also saw the birth of the Petro$, with all energy payments being made in US$, cementing the $s role as the world’s Reserve currency and allowing the US to perpetuate what the French referred to as an exorbitant privilege. We remain alert to the risk of a new conscious decision to devalue the dollar, something that would have clear implications for those with a lot of $ debt, principally emerging markets, as well as those seeking to compete with either US exporters – although these days not many of whom actually compete on price – or facing import substitution. From an investment perspective of course it would have implications for diversification of assets into other currencies and we suspect that this hedging of currency risk is well underway already. For the moment however, it looks like the current US Treasury have recognised that the opposite of John Connally’s statement is now true. It is a case of the US Treasury saying that Your Crypto currency or your competing Petro Currency that is now our problem. For those seeking to take on the US monetary and Fiscal authorities, it looks like the battle is just beginning.