Oil: The new global reserve currency

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With growing concerns about the dollar's weakness, driven especially by the ballooning U.S. national debt, there has been some talk lately about a new global reserve currency.

For a variety of reasons, the idea hasn't gained much traction in institutional circles. But that hasn't stopped traders and investors from creating their own, temporary global reserve currency of sorts: oil.

With equity markets failing to offer growth sectors capable of inspiring sustained investor confidence, and with continual chatter that high U.S. government spending to stabilize the financial system and provide fiscal stimulus will fan inflation, at least a portion of institutional investors are rotating out of the dollar and other investments and into oil.

Economist Richard Felson says the above is one factor why oil has soared by about 100% in six months, from about $36 per barrel to $72, as global oil demand fundamentals alone can not account for oil's rise. Oil traded Friday afternoon down 62 cents to $72.04. "There is the expectation that oil consumption in Asia and the Americas will increase with the economic recovery, but high oil inventories would normally counteract that bullish sentiment, and they haven't, which points to other price pressures on oil, including short-term traders and investors," Felson said Friday. "Historically, gold and oil have been inflation hedgers, and right now the market's voting oil as the 'temporary' global reserve currency until we get more data on how U.S. inflation is faring as a result of all this fiscal stimulus and Fed quantitative easing."

Oil as surrogate dollar: for how long?

How long will oil remain a surrogate for the dollar? No one can tell with any certainty, Felson said, but one way investors can monitor both inflation and the dollar's status is to keep close tabs on the price of key commodities: oil, gold, copper, wheat, and soybeans. Of those five, Felson said oil is the most important.

Because oil is now vital to both developed and developing economies, it has more inherent value and is more liquid than other commodities, hence institutional investors feel more-comfortable rotating money into it "because they know they can get out of it quickly if objective events turn against them," Felson said. "For those reasons, oil will rise with inflation concerns and if the dollar falls. If investors sense a rise inflation and a further fall in the dollar, oil will continue to move higher. However, if we don't see more inflation and the U.S. recovery improves the deficit picture and the dollar's outlook, look for oil to decline as investors rotate out it."

Further, Felson said not every economist, business executive, or public official is entirely comfortable with a financial system that attaches such weighty surrogate roles like 'temporary' reserve currency to commodities. It conjures up images of 'wag the dog,' where markets serve traders, not traders serving markets, but that is the undeniable reality of today's markets, he argued.

"We want the free flow of capital. We want price discovery. We want the more-efficient deployment of resources. All of these things require the strong position we've allocated to investment, hedge, and mutual funds, and that implies the types of movement of capital we've seen this decade," Felson said. "And absent changes, conditions in which a commodity can assume larger roles are entirely possible."

Economic Analysis: The free-flow of capital is essential. And the rotation out of one asset or commodity into another is fine. However, a problem occurs when institutional investors push prices up so high – and well beyond what fundamentals would dictate – that it decreases both consumer spending and business investment, hurting the economic recovery. That type of market circumstance, as another economist, Peter Dawson, has outlined, is both absurd and irrational. Hence, we need to monitor oil's price pattern this year, to see if, in fact, the institutional investor tail is wagging the U.S./global economy dog, or if oil's price rise is warranted, due to supply/demand factors, and/or other geopolitical issues.
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