What Happened In The Last Month?



The chart below shows it may be a mistake to assume the move in the dollar will not last very long. Like all the charts we present, the purpose is not to predict or forecast, but to understand possible realistic scenarios which could play out.



Secular and Cyclical Trends

The long-term story for a weak dollar remains intact. The long-term story for strength in commodities remains intact. These stories (or fundamentals) apply to a period that could last almost twenty years and are referred to as secular stories or trends. Based on history, it is important to understand that counter-trends or cyclical retracements of secular trends can be of significant magnitude and duration. More importantly, they can destroy principal even when you have correctly identified the long-term fundamentals. The chart below of gold prices from 1973 through 1981 illustrates the point. Even if you have the story right, are you willing and emotionally able to suffer a 48% loss in a core position?



The chart of the NASDAQ (below) illustrates our task, which is to balance the desire to stay with a secular trend with the need to protect against large and hard to recover from losses.



What Could Be The Motivation To Want A Stronger Dollar?

While complex financial markets never have singular and simple cause and effect relationships, we can identify a few of the major contributors to the significant shifts which have occurred in the last month. When examining the related movements between the dollar and commodities, the classic chicken and egg question always comes into play. Of the many possible reasons to set an orchestrated dollar move in motion are:

* A weak dollar has contributed to global inflation which cannot easily be addressed by central banks raising interest rates in the face of slowing economies and a credit crisis.
* European exports have been seriously negatively impacted by the weak dollar/strong euro.
* Additional evidence of European economic weakness has surfaced in recent weeks.
* The same issues, exports and economic weakness, also apply to the emerging market economies.





The major drawback for the U.S. is the weak dollar has helped fuel a significant increase in exports. The surge in exports has propped up America’s GDP in recent quarters. From the Saturday, August 16, 2008 edition of The Wall Street Journal:

"A stronger dollar, if sustained over a longer term, could put the U.S. economy on shakier ground by raising the cost of exports. Without the improving U.S. trade position, the U.S. economy would have contracted in the second quarter. Exports grew at a robust 9% annual rate during the quarter, helped along by the cumulative effects of the dollar's weakening in recent years."

When Fundamentals and Technicals Fail to Align

My read-between-the-lines of the current economic environment includes:

* The Fed’s attempt to prop up the economy by lowering interest rates has not and is not working, which is no secret to anyone.
* The availability of credit is contracting which is exactly what the Fed was trying to avoid by lowering rates.
* Stock markets around the globe are not anticipating a significant recovery anytime soon.
* Banks still have serious problems with continued deterioration of their balance sheets caused primarily by falling home prices, which have no rationale hope for finding a permanent bottom anytime soon.
* The recent slide in commodity prices underscores the contraction of credit, housing outlook, and anticipated future economic weakness. This is not good for stocks.
* At least for the time being, financial markets are placing economic weakness and the possibility of deflation ahead of any concerns about possible future inflation.
* All asset prices, including commodities, are on the ropes.
* Based on the evidence we have today, a rapid reversal in the U.S. stock market is possible between current levels and 1,365 on the S&P 500 (now at 1,298).
* A possible, but much less probable, outcome is for stocks to respond positively, in a rapid upside move, to falling commodity prices and break through 1,365. The basis for this scenario is that capital is flowing out of commodities and could rush into stocks if managers feel they are being left behind. The move could take the form of an upside "blow off" where the panic buying is quickly replaced with panic selling.

The concepts above appear to be supported by recent disconnects between some fundamental and technical elements in both commodities and stock markets.







Stocks Remain in Downtrend



At Some Point Nothing Else Matters Except Protecting Principal

When asked their secrets of success, money managers who consistently have been top performers almost without exception state the importance of "cutting losses and letting winners run." Similarly, when the best professional managers are asked to name common mistakes made by individual investors, they typically put the failure to cut losses at the top of the list. The cruel reality of the markets is when you lose 30% you need to make more than 30% to get back to break even. As the chart below shows, if you lose 30%, you need to make 43% to get back to break even. The two boxed rows show the danger of “staying the course” while bear markets destroy your hard earned principal. If you "rode out" the 2000-2002 bear market in the S&P 500 Index, your losses from peak to trough would have been roughly 45%. To get back to break even, you would have needed to earn an 82% return from the bottom which was made in October of 2002. When losses begin to pile up, at some point you have to put both the fundamentals and charts on the back burner and focus on preserving principal in order to have the opportunity to fight another day.



The previous statements and charts are not meant to be forecasts, but simply an assessment of current risk/reward profiles and probabilities as we see them. If the odds shift to more favorable or alternate outcomes, we are keeping an open mind and will gladly adjust our thinking as new evidence unfolds.

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com

Despite the high prevailing prices, demand in 2008 is expected to total 86.9 million barrels compared to 85.96 mb/d in 2007. For 2009, global oil demand is expected to reach 87.7 mb/d.



Anemic economic growth in the US, particularly in energy intensive areas such as construction and auto manufacturing, along with consumer resistance to high gasoline prices, is expected to cut into demand on an absolute basis with US disappearance expected to total 20.2 mb/d. The decline is likely to persist into 2009, with forecasted demand expected to total 19.8 mb. European demand given the significantly lower base along with the high retail prices will likely stagnate at 15.1 mb/d.

Due to the forecast for an absolute decline from the US and Europe, growth in demand will be reliant upon emerging market economies. In China, the domestic economy is beginning to show strains from high inflation which is encouraging an increasingly proactive role on the part of the government to moderate capital investment and likewise demand in order to control inflationary pressures. In India, fears have been apparent over the high cost of subsidizing domestic consumption of oil products. Subsequently, demand if anything might fall short of expectations as governments restrain growth through more rational pricing policies that do not strain national budgets. Subsequently, forecasts suggesting growth in Chinese demand in 2009 to 8.42 mb/d from 7.96 in 2008 might be overly optimistic. For non-OECD areas, demand is expected to reach 39.71 mb/d, an increase of 1.4 mb/d over forecasts for 2008. However, any shortfall in Chinese demand might hold out the potential for non-OECD demand falling short of forecast.

Supply Increases Enough?




Just as demand has responded to the higher prices, global crude oil supply availability has also started to expand. Although concerns remain over the depletion of existing fields in the US, North Sea and Mexico, high prices have encouraged an expansion in supplies from areas in Brazil, Saudi Arabia, Iraq and Nigeria. In addition, aggressive biofuel and LNG programs are beginning to have an impact. Only with higher prices could the gains in substitute programs and deep sea drilling have been achieved. The belief that the high price environment is finally becoming ingrained in assessing the potential profitability of projects is helping encourage investment, particularly in Brazil and the Gulf of Mexico. The high prices have also raised the pain threshold by which the costs, including environmental impact associated with drilling on the Continental shelf, are being reassessed.

Despite the favorable price environment, the gains on the production side are still not spectacular; yet appear to be enough for now to provide the basis for a balance tending toward surplus supply/demand situation. Led by steady gains in emerging markets and stabilization in developed areas, demand will eventually resume an upward growth path. The ability of supplies to keep up with these gains will be a key variable to the future price environment surrounding crude oil and the structure of its forward curve.

For 2009, global oil supplies including biofuels, natural gas liquids and condensate are expected on a preliminary basis to total 87.8 mb/d compared to 87.3 mb/d forecast for 2008. OECD supplies are expected to fall to 19.3 mb/d compared to 19.5 mb/d in 2007. European supplies are projected to fall the sharpest, reaching only 4.2 mb/d in 2009 compared to 4.5 mb/d in 2008. North American supplies will actually show an increase as production from the Canadian tar sands and higher US output attributed to further increases of ethanol supplies and expansion in production in the Gulf of Mexico more than offset declines in Mexico due to lower production from the Cantarell field.

In non-OECD areas, supplies are projected to increase by .5 mb/d to 28.5 mb/d. Major concerns are linked to the Russians, where abrupt policy changes and a punitive tax regime is discouraging investment. With uncertainty associated with the government support of joint ventures, foreign investment in new projects is likely to lag. A bright spot remains Brazil, but even there deepwater development will demand patience and substantial capital. In Asia, supplies are showing increases as the demand for energy remains buoyant and absorbs what increases might be attained in Vietnam, China and Thailand.

OPEC production levels led by Iraq and Saudi Arabia have continued to expand. Recently, OPEC production reached 32.4 mb/d. This is as much as 1.8 mb/d above year ago levels. Concerns had recently been expressed that due to dwindling spare capacity, OPEC had lost their pricing power. However, given recent declines it looks like the Saudis once again hold sway over the market. Currently they appear to have a desire for a stable price environment which will not threaten demand. What the breaking point might be on both the downside and upside remains to be seen but Saudi statements have tended to foreshadow any change in policy and will have to be watched closely. For 2009, it looks like sustainable capacity will likely expand by upwards of 1 mb/d. However, OPEC remains wary of committing further capital into new and expensive production until the depth of the recent economic slowdown and impact of renewables can be more accurately gauged. A move back below the 100.00 area could encourage calls by more radical OPEC members such as Venezuela and Iran to reign in production.



Conclusion




A surplus supply situation is likely as we move into 2009 based upon current supply/demand trends. Demand prospects will not only be influenced by apparent off take linked to economic activity but also by speculative involvement which will continue to be driven by the dollar and inflationary trends. Efforts to thwart institutional involvement will continue to be a potential weight on the market. On the supply side, Saudi Arabia will likely come under increasing pressure to cut production if prices break back near the 95.00 area particularly if the statistical balance has moved into surplus. Inventory levels, which have been slow to reflect a build in OECD countries, will need to be monitored closely. An increase in inventory levels would not only put pressure on prices but also provide validation to OPEC that supply availability has overtaken demand. The rebuilding in inventories could provide the basis for values falling back toward the 94.00 level, similar to what occurred in July of 2006 when values reached a high of 78.40 before falling back to a low of 50.00 basis the active contract. A key reflection point looks to be near the 110 level basis the nearby contract. Eventually OPEC looks like it will need to intervene and cut production to move supply/demand back into better balance.

Longer term, we see the potential for values to move higher as emerging markets try to satisfy a growing need for energy and production lags. Nevertheless, it will take time to shake off the economic malaise in the developed countries and rebuild demand growth in emerging markets.

Questions or comments about this article, please contact Steve Platt at 1.877.377.7931

The information and comments contained herein are provided as general commentary of market conditions and are not and should not be interpreted as trading advice or recommendation. The information and comments contained herein are not and should not be interpreted to be predictive of any future market event or condition. The information and comments contained herein is provided by ADM Investor Services, Inc. and not Archer Daniels Midland Company. Copyright © ADM Investor Services, Inc.

All Charts Courtesy of DTN.


About the Author


After graduating from Georgetown University in Washington, D.C., Steve Platt joined an economic consulting firm focused on agricultural policy and research. In 1979, he relocated to Chicago and worked for two major brokerage houses as Senior Analyst and Research Director, servicing the needs of both institutional and retail clients. In 1998, Steve set up and was given operational control of a trading desk at Morgan Stanley, DW Inc. specializing in precious metals, foreign exchange, and futures. The desk also serviced specialized spec and hedge futures accounts trading in U.S. and International markets. Over the years, Steve has been quoted in major financial publications and seen on a variety of financial news programs discussing market fundamentals. Steve can be reached at (877) 377-7931.

Source: FutureSource.com

Prestowitz is not a doomsayer, neither is he alone in his views. As president of the Economic Strategy Institute, a Washington think tank, he is in regular contact with the most influential US business leaders, several of whom -- Warren Buffet and George Soros included -- have taken steps to hedge their currency positions against the possibility of a cataclysmic plunge in the greenback.

"Right now," he says, "we have a situation in which the US is running huge trade deficits -- about $US650 billion ($766 billion) in 2004 -- which are financed by borrowings from the central banks of Asia -- mainly the Chinese and the Japanese. All the world's central banks are chock-full of US dollars -- they're holding many more dollars than they really want. They're holding those dollars because at the moment there's no great alternative and also because the global economy depends on US consumption. If they dump the dollar and the dollar collapses, then the whole global economy is in trouble.

"However, some countries have a bigger stake than others in maintaining the status quo. China and Japan have a big stake in maintaining the flow of their exports to the US and keeping the US economy humming. Russia, on the other hand, does not export much to the US. India doesn't export much to the US. Yet Russia and India are also big dollar-holders. They hold many more dollars than they really want or need.

"It doesn't take any great stretch of the imagination to see what could happen if one of these central bank managers decides to dump dollars. We had a situation recently when a mid-level official at the Central Bank of Korea used the word 'diversification'. It was a throwaway remark at some obscure lunch, but there was instantaneous overreaction. The US stock market fell by 100 points in 15 minutes because the implication was that South Korea might be shifting out of US dollars.

"So picture this: you have a quiet day in the market and maybe some smart MBA at the Central Bank of Chile or someplace looks at his portfolio and says, 'I got too many dollars here. I'm gonna dump $10 billion'. So he dumps his dollars and suddenly the market thinks, 'My god, this is it!' Of course, the first guy out is OK, but you sure as hell can't afford to be the last guy out.

"You would then see an immediate cascade effect -- a world financial panic on a scale that would dwarf the Great Depression of the 1930s."

Prestowitz says the panic could be started by something as simple as a hedge-fund miscalculation.

"We had exactly that scenario in the US recently," he points out, "when a big hedge fund called Long Term Capital Management went belly-up. These guys were pros. They had two Nobel prize-winning economists writing their trading algorithms, and their traders were the creme de la creme among New York bond traders.

"They made a big bet -- a trillion dollars leveraged 20 to one, and they blew it. They went belly-up. That threatened to bring down the whole system so US Federal Reserve chairman Alan Greenspan had to organise a bail-out through the Federal Reserve Bank of New York.

"Now consider this: there are currently 8000 hedge funds in the US alone. Every day $6 trillion of derivative instruments trade on international markets. If there are four people in the world who understand those trades, I'd be surprised. So the potential for another disaster is not insignificant. This is why Warren Buffet, chairman of investment giant Berkshire Hathaway, is betting $US21 billion against the dollar. This is why currency speculator and hedge fund manager George Soros has also made a big bet against the dollar.

"Soros is one of the greatest currency speculators of all time. He was the guy who broke the British pound in the early 1990s by betting $US10 billion it would fall. He made a quick billion when it did. In 2002, he warned that the greenback was in danger of losing a third of its value. Of course, it could be argued that Soros is a professional hedge fund manager whose job is to play the ups and downs of currencies and his remarks could be seen more as manipulation than prophecy. And yet, in conversations with me, Soros has expressed concern about the market fundamentalist view that prevails in Washington and parts of Wall Street.

"This is the belief that markets are self-correcting and best left alone. Soros calls this a dangerous siren song. Far from being self-correcting, he emphasises, markets tend to excess. They over-shoot. Anyone with any experience of markets knows this.

"When markets are going down, all the weaknesses get concentrated, and you need intervention at the right time to stop things from getting out of control. If the dollar started to melt down, the results could be really nasty. A 1930s-style global depression is not out of the question."

To underscore the point that he is not alone in this, Prestowitz cites Paul Volcker, head of the Federal Reserve before Greenspan, who has said publicly there is a 75 per cent chance of a dollar crash in the next five years.

"No wonder people look at this and say, 'Holy cow!'," he says. "No one knows for sure what will happen, but clearly the global markets could implode very quickly. The lack of an alternative to the dollar is the only reason it hasn't taken a big fall already."

Prestowitz, formerly a trade adviser and negotiator for former US president Ronald Reagan, believes the US will continue to be the world's most powerful economy for the foreseeable future. But he foreshadows an inexorable decline, a trend that is likely to continue "depending on the way we play our cards".

"Right now, we're playing them just about as badly as it's possible to play them, and that has geo-political implications." he says. "We've outsourced trying to deal with North Korea to China, we really can't deal with Iran, so we've outsourced that to the EU, which is struggling, and Iran is cozying up to China. Other bad actors like Zimbabwe's Robert Mugabe and Sudan are cozying up to China.

"America's global hegemony is already under challenge, and that challenge is going to become more and more evident as the extent of the relative US economic decline becomes evident. Right now, the US dollar is probably 40 per cent overvalued versus the Japanese yen or the Chinese renminbi. How's the US going to look as a global power when the dollar is at 50 per cent of its current value?"

Source: http://www.theaustralian.news.com.au/story/0,20867,16416680-28737,00.html

Given the strong price correlations between the two commodities, many economic commentators wrote of the gold/oil relationship in terms of a 15/1 ounce/barrel ratio. As the late Warren Brookes wrote in his 1982 book, The Economy In Mind, “In 1970 an ounce of gold ($35) would buy 15 barrels OPEC oil ($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels of Saudi oil ($32/bbl).

More modernly, in March of 1999 The Economist predicted $5/bbl oil in the future because “the world is awash with the stuff, and it is likely to remain so.” Instead, with the gold/oil ratio of roughly 25/1 historically out of whack, crude proceeded to rally beyond the 15/1 ratio; reaching $24/bbl by September of 2001.

Since 2001, gold has rallied powerfully owing to the dollar’s debasement over the same period. Unsurprisingly, oil has skyrocketed too. With many commentators on both sides of the political spectrum unfamiliar with the relationship between the dollar, gold and oil, apocalyptic notions of shortages and “limits to growth” have revealed themselves much as they did in the ‘70s.

More realistically, the oil “shocks” of this decade were rooted in dollar shocks that were bound to make oil dear in dollar terms. As of last month, oil since 2001 had risen over 380 percent in dollars versus 160 percent in euros. Though the numbers were different in the late ‘70s, this was not unlike oil’s 43 percent rise in dollars from 1975 to 1979; a “shock” that did not register in deutschemarks, yen and Swiss francs where oil rose 1 and 7 percent in deutschemarks and yen, versus a 7 percent fall in francs.

Last month, gold rose at one point to nearly $1,000/ounce, and oil hit an all-time high of $147/barrel. Since then, oil has fallen roughly 23 percent against a 17 percent drop in gold. So as is always the case, a large reason for oil’s current weakness has to do with a dollar that presently buys 1/827th of an ounce of gold, as opposed to nearly 1/1000th a month ago.

Still, oil has fallen further, and while rumblings of greater supply reaching the market due to presumption of liberalized drilling rules might explain some of the disparity, another realistic explanation lies in the aforementioned gold/oil ratio. As of last month, the ratio was roughly 6.8/1, so if history is any kind of indicator, oil was and is due for an even greater fall versus gold given the longstanding relationship between crude and the yellow metal. Looking ahead, no matter the direction of gold, oil has room for further weakness given a ratio that as of this writing is roughly 7.3/1.

What explains the dollar strength that has revealed itself in lower commodity prices? To some degree we can tie it to the coupled world economy that had never “decoupled” in the way so many pundits suggested. Simply put, dollar debasement regularly leads to world currency debasement, and with economies around the world struggling under the inflation that bats 1.000 when it comes to economic uncertainty, the severely weakened dollar has perhaps paradoxically been seen by investors as a safe haven in these treacherous times.

More interestingly, polls and market-based measures of political outcomes such as Tradesports.com point to a Barack Obama victory in November. Whatever his many policy faults, Obama recently met with strong-dollar advisors Paul Volcker and Robert Rubin, and not long after told a gathering of potential voters in Ohio that a strong dollar would help reduce the cost of fuel.

Obama’s new position dovetails nicely with a recent Forbes.com interview of McCain advisor, Douglas Holtz-Eakin. Holtz-Eakin talked up the value of a strong dollar, and this is very important for putting the dollar in play as a campaign issue. Looking past November, the markets are perhaps pricing in better dollar policy ahead, regardless of the winner of the presidential contest.

It’s also notable that Treasury Secretary Henry Paulson a few weeks back termed a strong dollar “very important.” The latter is a not insignificant improvement over his “the strong dollar is in our nation’s interest” comments that the markets understandably did not take seriously. Investors of course ignored Paulson’s boilerplate statements given the Bush administration’s anti-dollar stance that has revealed itself through a true policy of "benign" dollar neglect, tariffs on steel, lumber and shrimp, not to mention frequent jawboning of China over the value of the yuan.

If the long neglected dollar’s collapse is permanently reversed, look for lower commodity prices across the board. And while many commentators will say this is evidence of a weakening world economy, don’t be fooled.

Since 1971, all commodity “shocks” have been dollar shocks; the dollar’s debasement real inflation that has revealed itself through more expensive commodities and a weaker economic/investment outlook. Conversely, commodity weakness has regularly resulted from dollar strength that enhances the value of the money we earn, all the while leading to greater investment for inflation not destroying the returns gained from that same investment.

Put simply, the nascent bear market for commodities is a bullish economic turn for it signaling a resumption of dollar strength. If commodities continue to fall, this will be more evidence of better dollar policy that will occur alongside rising equity prices and a more economically confident electorate.

John Tamny is editor of RealClearMarkets, a senior economist with H.C. Wainwright Economics, and a senior economic advisor to Toreador Research and Trading. He can be reached at jtamny@realclearmarkets.com.

Currency traders consulted by Forbes.com said the slide in the dollar on Monday morning was a short-term correction to its recent rally, sparked by a rise in oil prices. Nomura analyst Peter Scullion said there was still a strong chance of the greenback continuing to build strength against the euro between now and the beginning of next year. "Some of the biggest macro funds will now be looking to establish long-dollar positions," he said. "We're going to see small periods like this where commodities and the oil price is a determinant factor on short-term moves on the dollar."

Crude oil rose for the first time in three days as a storm near Cuba prompted evacuations from rigs and platforms in the Gulf of Mexico, which account for about a fifth of U.S. production. Crude futures were up 68 cents, at $114.46, on Monday morning on the New York Mercantile Exchange, from $115.14 late Friday in New York. Copper for three-month delivery also jumped $80, to $7,440, on the London Metal Exchange on Monday morning.

Underpinning the dollar's recent rally have been growing concerns about the global economy. Last week, a spate of gross domestic product data showed that the economies of Germany and France had contracted in the second quarter. And on Sunday, the British Chamber of Commerce said there was a "distinct possibility" of the United Kingdom facing recession in the next six to nine months. (See "Recession Knocks On Europe's Door.") "With the latest indicators out of the United States, people are looking at signs of bottoming, whereas in Europe, it's just beginning its fall," said Scullion.

The iPath EUR/USD Exchange Rate (nyse: ERO - news - people ) exchange-traded fund, which provides exposure to the euro/U.S. dollar exchange rate, closed down 1.0%, or 56 cents, at $56.37, on the NYSE on Friday. It has fallen 7.2%, or $4.40, in the past month.

Source : www.Forbes.com

The plunge mirrors a similarly steep drop in August last year. Unlike last year, however, this fall has not been driven by Japanese investors dumping the currency, the chief currency strategist at Westpac, Robert Rennie, said.

Small Japanese investors have developed a lucrative line speculating on foreign exchange. A favourite trade is to borrow in Japan, where interest rates are low, and invest in Australia and New Zealand, where rates - and returns - are relatively high.

Mr Rennie said he was "very concerned" a speculative bubble was emerging, with Japanese retail investors rapidly increasing their total stake in the two currencies to $US30 billion.

"This is not long-term investment. This is short-term speculation, and the numbers that we are talking about are very significant," he said.

If Japanese investors do start to dump the Australian dollar it could head even lower. But Mr Rennie said the dollar would find plenty of support if it dropped too low.

The head of foreign exchange strategy at the Tokyo branch of the Royal Bank of Scotland, Masafumi Yamamoto, agreed the Australian dollar was unlikely to fall too far. But it would come under pressure if commodity prices continued to fall.

In recent weeks, global crude oil prices have fallen 20 per cent since record highs above $US147 a barrel. Base metal prices are also at six-month lows, driven by fears Asian demand is cooling.

A senior currency strategist at the ANZ Bank, Tony Morriss, said a key trade on currency and commodity markets in the past year was to bet on rising commodity prices and a falling US dollar.

"Both of those positions would have paid handsomely, but that's clearly being unwound," he said.

Mr Morriss said the severity of the recent changes suggested a fundamental shift in market views, rather than a brief correction. "The speed of the move that we've seen in recent weeks … would suggest that we are at a turning point.

"All the things that were very supportive previously [for the Australian dollar] have turned out to be eroded."