Nope! But we're getting there. That is, America is sleepwalking its way into poverty. China is performing a kind of financial alchemy. And Australia finds itself subject to American-style problems, but benefitting from China's Grand Economic Strategy.

But how about those powerful idealists on U.S. markets? Both the S&P 500 and the Dow were up nearly three percent. If you can believe it, they were led by financial stocks and retailers. Bank of America finished up 9.9% after Goldman Sachs put it on its "conviction buy" list. Home hardware retailer Lowes was up 8.1% after a survey of U.S. homebuilder confidence surged.

By the way, what the hell is a "conviction buy" list? Does that mean you can only recommend stocks in which the executives have been convicted of a crime? And if it means a share you can buy with conviction, is there a "non conviction buy?"

Can you see yourself calling your broker to say, "Hey Bob. I don't much like stock XYZ. Earnings suck. It's got heaps of debt. Management is incompetent. But stocks are rallying...so yeah...let's do this baby. Buy. Just... you know...don't do it with any conviction."

Does anyone still take broker recommendations seriously?

Still, the rally in U.S shares-based on whatever it is based-is giving some investors the impression that demand for commodities will increase if the U.S. and world economies begin to grow again later this year. We think this is the dying convulsions of the "green shoots" theory/sucker's rally. You know, the one that ignores another $1.5 to $3 trillion bank losses from residential and commercial real estate.

But if you're a market neutral trader, why complain? Crude oil prices surged 4.8% in New York. Part of that rise stems from a shooting war between Nigeria's government and rebels who operate in the Niger delta. It's another reason to be bullish on oil. Not only has capital investment in new supply crashed, existing supply comes from national oil companies who are likely to use oil as a strategic and political weapon. Or it comes from countries like Mexico, Nigeria, and Venezuela that have fiscal stability issues.

Incidentally, Nigeria supplies 2.1% of the world's oil each day, or about 1.76mbpd. It would be more if about 500,000 barrels of capacity weren't idled because of the ongoing guerrilla conflict. The slack in global oil demand from the worldwide recession has made people forget about how slim the margin in is between daily global supply and daily global demand. Any combination of even more reduced supply (inevitable with the cap ex collapse of 2008) and increased demand will put oil right back into the red zone.

What about metals? Copper was up too. It closed up 2.7% in New York trading. And hey, what's this? In late April we reported that China's State Reserves Bureau was stock-piling metals at low prices. Bloomberg reports today that, "China is stockpiling commodities such as copper and iron ore as part of a reallocation of its sovereign wealth amid concern that the value of its dollar assets may decline."

The report cites a Royal Bank of Canada report on China's strategy to hedge its risk of owning US$796 billion worth of U.S. government bonds and notes. "Increased spending on commodities represents a reallocation of China's sovereign wealth away from the accumulation of financial assets," said Royal Bank analyst Brian Jackson.

China, by the way, increased crude oil imports by 14% in May and imported a record 57 million tonnes of iron ore. In fact, the China Iron and Steel Association (CSIA) is trying to blame the import surge on speculators who are front-running what they think will be an increase in demand, according to an article in today's Australian.

Remember, the annual iron ore negotiations are part of this public hemming and hawing. Chinese buyers of Aussie ore want to talk down demand growth, which would suggest a lower contract price. The CSIA says six of the top ten Chinese ore importers in the first quarter were traders, not steel-makers. But www.steelguru.com is reporting that Chinese steel-maker Baosteel said earlier this week that, "orders from auto sector hit a new monthly record of 937,000 tonnes in May up 317,000 tonnes or 50% over April."

Hmm. China has a current steel-making capacity of 650 million tonnes per annum (mtpa) according to Boatel chairman Xu Lejiang. That sounds like too much.

Meanwhile, we can't go into it in great detail, but could the great U.S. dollar exodus be happening right under our noses? China has been busy setting up bi-later currency swaps with its trading partners. The purpose is to settle cross-border transactions in currencies that are not the U.S. dollar.

Today's Financial Times reports that, "Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil's central bank and aides to Luiz Inácio Lula da Silva, Brazil's president. The move follows recent Chinese challenges to the status of the dollar as the world's leading international currency."

China's government has set up currency swaps with Hong Kong, South Korea, Indonesia, Malaysia, Argentina, and now Brazil. The purpose of the swaps varies from county to country. But the main benefit is that China can conduct more of its trade using its own currency and not the U.S. dollar. It also is a kind of vendor financing deal in which China supplies currency to countries from which it buys a huge amount of commodities (Argentina and Brazil, not yet Australia.)

Does it mean the remnimbi is the next world reserve currency? Nope. But it does mean that the Chinese are not looking to accumulate large financial reserves held in U.S. dollars any longer. They believe it's better, judging by these actions, to accumulate real assets that will be needed in the future by Chinese industry and Chinese consumers.

And what about all those dollars? Well, most of China's dollar reserves are held via U.S. Treasuries. And it's possible China has been performing a kind of financial alchemy, turning financial reserve assets into tangible commodity stockpiles. As this article points out, you'd think it'd be easy enough for Chinese holders of USTs to loan them to U.S. banks (who just love that sort of collateral at the moment) in exchange for cash which can be used to stockpile real stuff. It would be a clever trade.

Australia, of course, would stand to benefit from that trade. As Glenn Stevens pointed out in his speech to the Canadian Australian Chamber of Commerce, Australia's exports are biased towards commodities rather than manufactured goods. He says this has cushioned Australia from the world-wide slump, without damaging the huge improvement in terms of trade.

Why have Australia's export volumes not weakened. Stevens says that, "One reason is that the slump in global trade was initially concentrated heavily in manufactures, which is a smaller share of exports for Australia than others. Another is the stronger linkage of key commodity exports to China, which appears to have seen a pick up in growth this year."

"Chinese industrial output fell for four months between July and November, but has since recovered all those losses. A similar pattern has been seen in Korea, where industrial output suffered a sharp decline around year end but apparently made up about half of that over February and March.

Getting More and Paying Less: The Terms of Trade Improve and Correct

"Looking ahead, with commodity prices at present levels, Canada's terms of trade look like they are still somewhat above the average for the preceding couple of decades. Australian resource producers have accepted lower prices for the year ahead, and this is likely to contribute to a decline in the terms of trade by the end of 2009 of about 25 per cent from the peak, as shown in the chart [above] Yet even with that, at this stage Australia's terms of trade over the coming year look like they will still be around 40 per cent above the two decade average up to 2000."

Hmm. Well, Stevens is right that the terms of trade are still well above the two-decade average. And when you are paying less for your imports but receiving more for your exports, that is not a bad position to be in. But where will they go from here? Would Australia benefit or suffer from a bi-lateral currency swap with China? More on this subject later.

Finally, we feel compelled to point out that Housing Industry Association Chris Lamont has said, "There has never been a better time to enter into home ownership," in Australia. Someday he's going to regret saying that.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• China Has Stopped Stockpiling Metals
• The Iron Ore Pricing War Between China & Australia
• Gorgon LNG Deal with China a Really Big Deal
• RBA Leaves Rates Unchanged, Rio Wraps Up Negotiations

However, Soros warned that the oil bubble wouldn’t burst until both the United States and British economies slipped into recession, after which, oil prices could fall dramatically. “You can also anticipate that the bubble will eventually correct, but that is unlikely to happen before the recession actually reduces the demand. The rise in the price of oil and food is going to weigh and aggravate the recession.”

It’s dangerous to pick a top in a raging bull market, since bubbles can inflate more than anybody could have imagined. On May 20th, T-Boone Pickens told CNBC he expected crude oil prices to keeping going up. “I think we’ll get to $150 this year,” he reckoned. The next day, soon to be deposed Israeli PM Ehud Olmert called for a U.S. naval blockade of Iran, and if that happens, crude oil could hit $200/barrel.

Who is inflating the bubble in the global oil market? The Federal Reserve is the chief culprit, by slashing the fed funds rate 325-basis points to a negative -2%, after adjusting for inflation, and expanding the US-M3 money supply by 16.5% from a year ago, in a desperate effort to stop the slide in the sinking US banking sector. By slashing interest rates deep into negative territory, the Fed encourages speculation in commodities by pushing down the dollar, which in turn, is pushing up the price of dollar-denominated commodities, such as crude oil and gold.

So far, the Fed’s aggressive rate cuts haven’t found any meaningful traction in the S&P Banking Index, which is still languishing at the March lows, and -40% lower from a year ago, with banks posting hundreds of billions in losses from toxic sub-prime mortgage debt. The Fed’s single focus on rescuing the banking sector, with no regard for the inflationary consequences of its actions, has led to the emergence of the “crude oil vigilantes” who punish central bankers with sharply higher oil prices, whenever they become too abusive with the money supply.

In the past, a sharp slowdown in the U.S. economy, the world’s biggest oil guzzler, usually pushed the price of crude oil and other commodities lower. But the Fed was caught by complete surprise, after crude oil prices doubled, even as America’s economy slipped into a recession in the first quarter. “The current oil price has no relation to market fundamentals,” explained Saudi oil chief Ali al-Naimi on March 5th. “It is linked to tremendous speculation in crude oil futures. There are even those who buy futures and speculate that oil prices will reach $200 in 2013,” he said.

On April 28th, OPEC chief Chakib Khelil observed that crude oil prices were climbing, “even though supply is adequate, because the market is driven by the dollar’s slide. Each time the dollar falls 1%, the price of the barrel rises by $4, and of course vice versa. If for instance, the US dollar would strengthen by 10%, it is probable that oil prices will fall by 40%,” he figured.

But such simple logic has its limitations. China, India, Russia and the Middle East combined, are now consuming more crude oil than the US, burning 20.7 million barrels a day, up 4% from a year ago, according to the IEA. The emerging economies are picking-up the slack in the oil market, more than offsetting a -1.3% contraction in U.S. oil demand to 20.3 million barrels this year. Thus, a mild recession in the Western economies and Japan might not weaken global demand for oil.

Economies of big oil-exporters in Russia, Mexico, and OPEC itself are growing so fast that their need for energy within their own borders will limit how much they can sell abroad. Internal oil demand in Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates, grew 6% last year, and their exports declined 3 percent. Mexico’s oil output fell -9% in the first four months of 2008, from the same period a year earlier. If these trends continue, global crude exports could fall by 2.5 million barrels a day by the end of 2010, adding new strains to the global oil market.

If crude oil speculators on the Nymex were buying “black gold” as a hedge against the U.S. dollar’s slide against the euro, the #2 reserve currency, then perhaps, traders in London were buying North Sea Brent as a hedge against the British pound’s devaluation against the Euro. The Bank of England engineered the British pound’s sharp devaluation against the Euro, by joining the Fed’s rate cutting spree last November, with three quarter-point rate cuts to 5 percent.

The euro soared 17% to 80-pence, while at the same time, North Sea Brent crude oil prices doubled to $130 /barrel. Flipped the other way round, the British pound buys around €1.25, down from €1.50 last summer, making European imports considerably more expensive. For Ivory-Tower economists, the euro’s ascent against the British pound and U.S. dollar, which closely tracked North Sea Brent was just a statistical coincidence. But for crude oil speculators, the sharp devaluations of the pound and U.S. dollar translated into enormous windfall profits in their brokerage accounts.

When riding the waves of a bubble, it’s always good to have the basic fundamentals are your side. Oil production is shrinking in 54 of the world’s top-60 oil producing nations, including Britain’s North Sea, where output peaked in 1999, and has already plunged by half. The United Kingdom began importing liquid gas, for the first time in history in July 2005, and its North Sea oil reserve is dwindling at an -8.5% annual rate. The curtain might fall on North Sea Brent by 2012, if enough isn’t done to maintain development and exploration, according to the U.K. Offshore Oil Industry.

But political pressure on the BoE for more rate cuts could intensify, after British home prices dropped for the eighth straight month in May, down -2% from a year ago. The average selling time for U.K. homes has climbed to 9.8-weeks, compared to 5.8-weeks in May 2007. A further slide in home prices could topple the U.K.’s asset based economy into recession, and deepen losses for British banks. Another round of BoE rate cuts could renew selling pressure on sterling and buoy oil prices.

Currency devaluations do not fully account for crude oil’s dramatic rise to as $135 /barrel last week. “Peak Oil” theorists have a better explanation, and Saudi Arabia’s threat to ramp-up oil production by 2012 is sounding hollow. However, currency swings do magnify the volatility and price trends in the crude oil market, the same way the “yen carry” trade magnifies swings in the global stock markets.

No market travels in a straight line forever, and shakeouts in the crude oil market are designed to wipe-off the speculative froth. However, a British and U.S. economic recession would not necessarily burst the oil bubble, if the net result is another sharp devaluation of the British pound and U.S. dollar in the foreign exchange market, which would support high oil prices.

Gary Dorsch
for The Daily Reckoning Australia

• Crude Oil Extends its Price Decline
• How to Buy Crude Oil for US$2 a Barrel
• Crude Oil Becoming Much Harder to Find
• Two Reasons the Price of Crude Oil has Increased
• Oil Price Chart Shows Slight “Correction” in Near Future