As China goes, so goes oil; as oil goes, up goes the U.S. dollar

I realize it’s never easy and rarely simple. But today I’m going to help you understand why global money-flow drives key markets and how that flow could be reversing. If I am right, it is good news for long-term dollar bulls like me, bad news for China bulls, and terrible news if you are still riding on the Peak Oil bandwagon expecting oil to hit $200 barrel soon.

Three major realities lead me to those conclusions:

Reality #1—
Foreign exchange reserves and
growth is falling in China

Some experts estimate that up to $50 billion a month is exiting China. Keep in mind, when money leaves China, it leaves as dollars for the most part. Investors exchange yuan for dollars inside China, or Hong Kong, then move those dollars to safe haven areas, such as U.S. Treasuries, U.S. farmland, or Vancouver apartment buildings.

Year-on-year change in Chinese
Foreign Exchange Reserves Growth

Click the chart for a larger view.

Reality #2—
Demand for oil is falling along with
global growth, and the U.S. is leading the way

China’s crude oil imports fell 3 percent in July from a month ago to a nine-month low.

The slowdown in growth is hitting oil demand hard in the country that has driven the increase in global fuel consumption for a decade. In fact, the International Energy Agency slashed its forecast for Chinese oil demand growth in 2012 by a third to 240,000 barrels per day (bpd) in its August monthly report. Just a month earlier, the agency had forecast growth of 360,000 bpd.

And in the U.S., according to Reuters, oil demand in July fell to its lowest level in nearly four years.

If demand is already low and appears to be heading lower, I think it is time to mark down oil prices.

The chart below shows oil hit a brick wall of resistance at around $98 per barrel; that happens to be a key retracement level. Plus, the price oscillators are turning down from an “overbought” level. This price action seems to be confirming bearish fundamental news.

Click the chart for a larger view.

Reality #3—
The dollar is the
world’s monetary standard

The demand for dollars is poised to rise as the supply falls. I say that because:

• Dollar-based funding (supply) for trade finance and other credit lines is falling as European banks reduce the percentage of debt on their balance sheets.
• As I explained above, dollars are leaving China. And I expect China’s foreign exchange reserve hoard to continue to decline.
• Falling oil prices are dollar bullish, as countries that buy oil on world markets — priced in dollars — can reduce their dollar credit lines, which reduces the potential of a new supply of dollars from coming on the market.
• If a global credit crunch similar to the credit crunch of 2007 materializes, demand for dollars and dollar-safe havens will soar.
• Now, take a look at the chart below, which shows how all of these global money-flow factors discussed above relate to each other.

  Chinese foreign exchange reserve growth (red line);
  oil prices (black line); and the U.S. dollar index (blue line)

  
  Click the chart for a larger view.

  As you can see …

  There is a lagging correlation between Chinese FX reserve growth and oil prices, with Chinese FX growth leading.

  There is a tight negative correlation between oil prices and the dollar i.e. as oil prices rise the dollar tends to fall and vice versa.

  If these macro trends continue to play out as I expect, your decision is easy: Sell oil, buy the dollar, and hold those positions until the trend changes.

  Have a safe and happy Labor Day weekend,

  Jack

Money and Markets