Dollar Crisis & Commodities Outlook

Ever since the US Financial Crisis started, many investors have been asking the question why are the US stock markets so much more resilience in this storm as compared to the Asian stock markets during the Asian Financial Crisis of 1998. I think one of the main reason is the absence of a currency crisis; something that is quite unlikely to happen as well as the US dollar remains the reserve currency of the world. However, that day may have finally arrived.

Last Tuesday, the Fed announced that it would "cut interest rates to between zero and 0.25 percent, coupled with a promise to keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in U.S. government debt." Thus, the US has now started down the road of Quantity Easing ('QE'), something which the Japanese had tried with limited success in order to revive her economy.

It will be noted that the US QE will be greater in magnitude & wider in scope than the Japanese QE. "In quantity terms, a comparison of the US QE with that in Japan shows that, during just the first four months (16 weeks), the US monetary base has soared by 97.2% compared to a modest 6.7% at this point in the Japan QE cycle. Indeed, even after the first year the Japanese monetary base had risen only 32.5%". The second major difference is that Japan "focused primarily on getting the banking sector to lend again by buying up government bonds to boost reserves, the US is snapping up a variety of assets including commercial paper, MBS, etc." With the wider scope, it is hopeful that the US QE will be more successful than the Japanese QE. This comment was made by a post entitled "That's not quantitative easing..." from ftalphaville.

In an article entitled "The Dollar Crisis Begins", John Hussman has made a few interesting comments:

Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.

And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.

In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.

As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

With this background, let's examine the performance of the US dollar ('USD') over the last few week. The December 16 decision to engage in QE by the Fed has resulted in the USD plunging below its medium-term uptrend line. Despite the rebound over the last 2 days, the USD is still below the uptrend line. Over the next few months, I believe that the USD is likely to slide further & probably stabilizing at the strong horizontal support of 71-74.


Chart 1: USD Index's daily chart as at Dec 22, 2008 (source: Stockcharts.com)

In the past, we can see that the price movement of Commodities in general & Crude Oil in particular have a close inverse correlation to the movement of the USD (see Chart 2 below). However, you can see that this inverse correlation seems to be breaking down for a few days when the USD went into a free fall (i.e. from December 11-17), with CRB & WTIC failing to spike-up. There are two possible explanations for this; either the commodities players do not believe the USD can drop any further or the demand destruction in the present economic environment is so severe that commodities players chose to liquidate their position in any rally rather than adding to their position. Only time will tell what would be the outcome of this tussle.


Chart 2: The daily chart of USD vis-a-vis CRB & WTIC as at Dec 22, 2008 (source: Stockcharts.com)

One commodity which has definitely benefited from USD's recent free fall is the gold. Gold has rebounded back above its immediate uptrend line (S2). Its overhead resistance (R) is at USD950-960.


Chart 3: Gold's monthly chart as at November 28, 2008 (source: Supercharts by Omega Research)

We have been looking at the USD crisis & the likely positive impact on Commodities' prices. The anticipated positive effect of a weakened USD on Commodities' prices seems to be waning. We will track this closely & hopefully the inverse correlation return to give a boost to Commodities in general & our CPO in particular.