from Follow the Money

Greenspan’s conundrum and oil

June 8, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The most profitable sector of the Chinese economy, according to data from UBS. Mining. It is not even close. I presume that includes mining for oil. Remember that. I will return to it in a bit.

Alan Greenspan is puzzled. Every time the yields on the ten-year US Treasury note -- the benchmark long-term interest rate in the US -- heads toward the levels he expects, the market pushes yields back down.

The unusual behavior of long-term rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived.

It is pretty clear what happened last summer. Japan intervened like crazy in the winter and spring, and then invested all the dollars it had bought in the foreign exchange market in the Treasury market in the summer and the fall. That had an impact.

I at least don’t have a clear idea of what has happened this spring. Something pushed yields up in March -- maybe sales by Norway’s oil fund played a role, or maybe it was something else. But something or someone has pushed yields back down. Short covering explains some of the move, but not all. And you can decide for yourself whether or not you think falling long yields signal an upcoming global slowdown. Kash goes through the range of possible explanations.

I suspect that Asian central bank buying still matters -- though right now the Asian central bank that matters most is the People’s Bank of China, and it is hard to track what it is doing in real time. But I have a sneaky suspicion we will be surprised by size of the increase in the PBOC’s May reserves, particularly after adjustments are made for valuation changes.

Remember, the 4.4% fall in the euro during the month of May reduced the dollar value of the euros held by the world’s central banks. Thailand and Korea are reporting smaller dollar reserves for May -- and Thailand has not reported for the last few days, when the euro really fell. Russia’s foreign currency holdings are down, but including "other reserve assets" its overall reserves are still up. No doubt they would be up more if not for "valuation losses" on their euros. India’s reserves are up too, but not by much, and it has not reported its end-May total yet either. Malaysia’s reserve data will be out tomorrow.

I suspect the Federal Reserve’s models do not pick up the full impact of central bank intervention in the market. For one, I don’t quite see how you can really get a good test of the impact of current, massive central bank buying using data from the 1990s, when the US was running a fiscal surplus and central bank intervention was a lot smaller. Central bank intervention that keeps the dollar strong also keeps inflation low, and thus influences domestic market participants. And I suspect that the data series that are used in the statistical tests don’t pick up all central bank purchases of US dollar assets.

At the same time, I increasingly think Asian reserve accumulation is only part of the story.

Remember those mining profits in China. Exxon has decent profits too. Looking around, it is pretty clear that anyone with a (producing) oil field is swimming in cash.

Now it may be true that higher oil prices are not slowing the economy the way they used too -- though there are now some signs the global economy is starting to cool off. Demand shocks certainly are different from supply shocks. But selling oil in the middle of a demand shock is still a lot of fun -- everyone is pumping flat out, and still getting close to $55 a barrel.

(Continues)At about this time last year, oil was trading around $35 a barrel. Now it is a bit under $55 a barrel. Call in the interaction between rising demand and if not peak oil, at least less than robust production growth.

I did some very rough calculations to try to estimate how much more money OPEC gets when oil is at $55 rather than $35. Try $200 billion. The Saudis alone get an additional $70 billion; the oil states of the Persian Gulf get $150 billion. Russia -- a non-OPEC state -- in the same league as Saudi Arabia.

It is no stretch to estimate that the major oil producing states - non-OPEC as well as OPEC -- are making about $300 billion more than they would have expected this time last year. And at least for now, they seem to be saving it rather than spending it -- with some obvious exceptions (Venezuela). That must be contributing to the global savings glut in a big way. There are lots of petrodollars, and petroeuros, floating through the eurodollar and euro-euro markets (offshore markets).

Add in the $300 billion that China and Malaysia -- the dollar peggers -- look set to add to their reserves, and you have identified a large chunk of the incremental financing the US needs to run its $800 billion plus current account deficit.

The remarkable thing is that the oil exporting emerging economies right now are running massive current account surpluses -- and so too are some oil-IMPORTING emerging economies. China for example, imports enough oil to drive up its global price, but still looks set to run a 7 or 8% of GDP current account surplus. Back in the 70s, the petrodollars were recycled - in no small part by big New York banks -- to other emerging economies who had to borrow to afford (more expensive) oil imports. Not today.

One aside -- I am not quite as convinced as Chairman Greenspan that central bank demand does not also contribute to low European yields. Clearly it is not the only factor, but it could be a factor. If the world’s central banks add $600 billion to their reserves, $400 billion in dollars and $200 billion in other currencies, then they will be buying a fair amount of euro-denominated debt as well as dollar denominated debt. And if a few petrosheiks keep at least some of their savings in euros, that generates even larger inflows. Those inflows bid up the price of European debt, driving the yield down -- and help prompt Europeans to invest their savings in dollars (remember, the eurozone doesn’t have a savings surplus -- its current account is in rough balance).

A final housekeeping note: I will be traveling for the next week. There is demand for people willing to talk about China these days. I intend to try to post while I am on the road -- I should have access to the internet. But my posts likely will be a bit more sporadic -- and the "link density" of my posts will probably fall.

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