Dollar Daze

August 13, 2008

The extreme volatility of the commodities markets these days can make it hard to see what's really happening. Neusner examines the big trends.

  • Has the dollar really reversed course?
  • Why is oil really falling?
  • What could reverse the reversal?

 

The dollar's long downward slide may be over, but more significantly, a bull market of historical proportions in commodities may be on its last legs. The two trends are by no means unrelated, and it's not coincidental that they're happening simultaneously. There are both fundamental and speculative reasons for both trading patterns. Let's take a closer look and see why they're happening and what they mean.

The dollar has been gaining some impressive ground, now trading at its strongest level in almost six months, and has risen almost 8% since hitting a low in March. The greenback's recent ascent is being driven by a couple of factors. First, the Fed is taking a tougher public stance against inflation by signaling it won't cut interest rates any further. The Fed ended its rate cuts in April, then increased its inflation rhetoric, and in August said in the face of weakening economic activity that it had "significant concern" regarding the upside risks to inflation. The expectations for higher interest rates - or for interest rates not to go any lower - can support a currency by making a country's assets look more attractive, since investors earn a higher return on funds.

Weakening Global Economy 

Second, the global economy is weakening. According to Tony Crescenzi, chief bond market strategist of Miller Tabak, England is moving toward recession, Germany is expected to post a negative GDP reading for Q2, Japan is moving toward recession and even China is showing signs of slowing. Just last week, the head of the European Central Bank voiced concerns about Europe's growth prospects, which spurred foreign exchange traders to revise their bets that the ECB would raise interest rates later this year. Looking East, China's July consumer inflation slowed, giving the Chinese more leeway to cut rates, which should deflate the yuan. As the rest of the world weakens, the U.S., and the dollar, look better on a relative basis, despite the fact that the U.S. economy is also struggling.

Meanwhile, as the dollar strengthens, investors have been dumping once-popular commodities like gold and platinum, and oil has slid. The two trends - dollar up, commodities down - are not unrelated. In recent years, the dollar has demonstrated an almost perfect inverse pattern versus energy prices. This is not by coincidence - commodities generally move in contrary direction to the dollar as an inflation hedge. The pattern has sustained itself; except this time, it's going in reverse.

As the dollar has started to climb, oil showed signs that its long rise may be over. For instance, oil markets would normally react negatively to news of war in the Caucasus, a critical oil-exporting region. The fact that crude prices kept falling in the wake of the Russian invasion of Georgia suggests that traders are now overwhelmed by a belief that the world economy is in worse shape than expected.

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