A riyal pain in the...

Question:   If a market falls and there is no one there to panic, does it make a sound?

Yesterday's price action was notable for a) unwinding the vast chunk of Friday's euphoric price action in equities and crude b) the fact that other markets just didn't seem to care.   Sure, fixed income rallied, but in Europe it was going up anyways and in the US a sense of "just get me into something safe" was palpably absent.   USD/JPY, meanwhile, which lost no opportunity to drop last week, couldn't be bothered to lift a finger yesterday.  Finally, even the comments section in this space was relatively subdued compared to the activity of recent weeks.

Maybe it's just Macro Man trying to fit a narrative to the apparent lack of interest from his market interlocutors, but it really just felt like many people were content to sit back and watch.   Stories are already rumbling of the biggest pension fund re-balance in three and a half years  come the end of the week/month, so perhaps that will dissuade some of the friskier shorts from pressing their bets.  To be honest, Macro Man isn't sure whether all of this is a reassuring sign of a more balanced market...or a sign of complacency heralding further blood on the street down the line.  Either way, he is bemused by those that can have strong convictions in this environment on time frames that are dominated by noise, rather than signal.

And now for something completely different.

One of the more interesting features of the global economy and markets over the past couple of years is the way that they have exposed fault lines in weak economies and institutions.  China is an obvious example, as are Brazil and Russia.  The latter of these, of course, has been hit not only by economic sanctions, but also more viscerally by the collapse in oil prices.   In this, they are far from alone; just look at high yield and USD/CAD, last week's price action notwithstanding.

Of course, the entity most obviously affected by the decline in oil prices is Saudi Arabia, one of the world's largest oil producers with a decidedly non-diversified economy (energy represents something just shy of 75% of total tax revenues, down from more than 90% a few years ago.)  The deterioration in the country's external and internal finances has led to speculation of an official devaluation of the riyal.

Of course it wasn't that long ago that markets were pushing for a revaluation of the SAR and other GCC currencies, thanks to double digit inflation pressures at the height of the oil boom:

Those pressures, of course, petered out, both because of the refusal of the GCC authorities to address the issue, and the small matter of the global financial crisis doing away with any inflation problems in these countries.

Now, of course, there is a different set of issues, most namely a gaping hole in the Kingdom's finances, and a resulting erosion in the country's FX reserves.   Government revenues have fallen by more than 50% since 2012, and the budget balance has collapsed from a 13% surplus that year to what looks like a 15% deficit this year.  Of course, such volatility in the Saudi budget is not without precedent; following the oil glut of the mid-80's, the Kingdom's budget deficit reached 25% of GDP in 1987.  It should be noted at this juncture that having devalued the SAR to 3.7450 in June of 1986, the authorities did not touch it again during the final budget blowout...or the subsequent recovery in oil or the country's finances.   This was in direct contrast to their behaviour in the 1970's when the SAR was first revalued against the USD and then pegged to the SDR, which was tantamount to the same thing.

At the same time, it should be noted that while Saudi Arabia's external balances have obviously deteriorated sharply, the deficit remains fairly modest in comparison with prior surpluses.  Indeed, it could probably be financed through the sale of citizens' holdings of property in Mayfair alone!

In any event, there is one regional currency that does float (a bit) with the ebb and tide of the GCC's favorite export: Kuwait.   Unlike the SAR or AED, it did strengthen in 2007 in response to domestic inflation pressures.   Now, it's weakening in line with the decline in oil revenues.   To date, everything looks pretty much consistent with historical precedent.  If there were evidence from KWD were to weaken substantially further, that could be a signal that legitimate pressure is likely to mount upon the SAR.   As of now, however, the canary is alive and well.

Ultimately, the SAR is a political trade much more than it is an economic one.   In this, it resembles Hong Kong much more than it does Russia or Brazil.   To be sure, economics can exert pressure on the politics (viz. 1997 in HK the oil price dumps of the mid 80's and late 90's in the KSA), but then again, the reverse is also true: last week the Saudi authorities basically banned local banks from quoting SAR options.

While Macro Man certainly understands the idea of being long USD/SAR as an asymmetric bet, he's gotta believe that there are better trades out there driven by more transparent factors than Saudi politics (what with the dog-fight for the succession, etc.)  Hell, if Saudi Arabia really were planning to flog off part of Aramco, that could also enter the equation.  In any event, a history lesson is also probably useful; the 1 year forwards have been quoted around 900-1000 pips over the last couple of weeks;  in the 1980's, the biggest annual depreciation that Macro Man could find for the SAR was....1000 pips.  Granted, most of those decision-makers are probably now dead, but it does give you an idea of the gradualism that has traditionally characterized the Saudi currency regime.  Paying current levels looks very likely to produce a riyal, sorry royal, pain in the P/L.

And hey, if you absolutely must play a currency peg, why not look at Hong Kong?  You can buy a 1 year 7.85/7.75 1 x 2 put spread (ie, owning the entirety of the peg range) for a modest credit.    Sure, 1 x 2's carry risk...but in the highly unlikely event of a peg break, do you really think it would be to the downside?  Pricing that strike at roughly the same vol as the 7.85's is just wrong wrong wrong; anyone with the cojones to take the other side will almost certainly be glad they did.


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