FYI | Sep 12 2008
By Greg Peel
The euro has now fallen below US$1.40, implying a rally in the US dollar of 12.5% from the low (high in the euro) of US$1.60, which was hit more than once this year. The fall of the dollar to the US$1.60 level was all about the credit crunch, the Fed’s interest rate cuts, and fears for the US economy. The US$1.60 level held because hints emanating from the G7 finance ministers were that if that price were to be breached the world would need to step in and save the reserve currency. Traders became reluctant to test the G7’s resolve.
When the US was collapsing all about the place in the first half of 2008, most notably in the financial sector, the general view remained that the economies of Europe, Japan and China would not necessarily follow the US down, or at least not by as much. No more was this evident than in the fact the ECB held its rate steady at 4.00% before ticking up to 4.25%, the BoJ has remained at 0.5%, and all of China’s initial interest rate moves were up. All this while the Fed cut from 5.25% to 2%.
In Australia, the view was even more emphatic that China was now the driver and the US situation mattered little. The strength of Australia’s commodity-based economy saw the RBA raise its interest rate from 6.00% to 7.25%, such that the differential between US and Australian rates blew out from 0.75% to 5.25%. That is why the Aussie pushed towards parity.
How quickly things change.
The Aussie dollar has almost fallen 20% against the US dollar in record time. The speed of the move has shocked many, but it is a combination of a slowing domestic economy and falls in commodity prices that have conspired to take the wind out of the Aussie’s sails. Weakness in the domestic economy has already triggered the RBA’s first rate cut, and the expectation is that the balance of trade will also drop away on lower commodity prices, thus removing the inflation pressure in the domestic economy. All this means an anticipation of several rate cuts from the RBA, and hence a trashed Aussie.
Over in Europe and Japan, signs very quickly emerged that those economies were also contracting, and contracting faster than an apparently stable US economy. That is what has set the US dollar running against the euro and, to a lesser extent, the yen. In the yen’s case there is a counter-force of carry trade unwinding out of currencies such as the Aussie, which has also added to the Aussie’s sharp weakness.
There is little doubt the Aussie is oversold right here and now, but it’s never advisable to jump in front of a bus when it takes a bus quite a distance to stop. It is also now felt that the US dollar is overbought, so that may end up being the factor which pulls up the Aussie. Dennis Gartman has this morning suggested that the US dollar has become “egregiously overbought and is due for a very sharp and very material correction”. Gartman suggests US$1.40 was the forex market’s “target”, and that has now been achieved.
Were the US dollar rally to hit a correction, one might safely assume this would pull up the current drop in the prices of commodities and gold. However, one must also consider it’s a case of just who is leading whom.
The US dollar is not “strong”, it is just that the economies behind other world currencies have become weak. The sudden sharp fall in commodity prices flowing from this weakness is as much a reason that the dollar is being pushed up rather than a stronger dollar forcing down commodity prices. The oil price, for example, is now down over 30%.
The analysts at GaveKal have pointed their fingers at the “redemption cycle” in commodities funds. Investors keen to get out of commodity plays have hit funds with redemption requests, and the nature of redemptions is that they usually are only possible during certain “windows” rather than at any time. So there will have been investors desperate to reverse positions as soon as commodity prices began tipping over, and who have been stuck on the sidelines ahead of their windows fretting about the sudden falls. Once the windows open there is then a rush. This forces those funds to sell out of their commodity positions to raise cash and to do so at the same time as their peers, causing these sharp drops.
This again suggests an oversold situation, but again that bus is still moving fast as perceptions of global economic weakness continue to accelerate. Barclays Capital notes this forced selling rush has meant normally bullish factors, like announced OPEC oil, cuts are simply being ignored. Base metals such as nickel and zinc are now trading below their costs of production, implying peripheral supply will be shut down, but still these metals are being sold.
Barclays does note, however, that the bulk of selling is coming from commodity-based exchange traded products and not from commodity index funds. There has been very little variation in index fund positions, the analyst report. “Our analysis based on industry sources,” they note, “supports the view that investor flows both in and out of commodity indices have been insignificant this year”.
What does this mean?
Well the implication is that while investors have been bailing out of individual commodity positions, such as ETFs specifically for oil, or metals or gold for example, in a frenzy, the more general asset class of the commodity index fund has not seen massive divestment. The next question, however, is: is this good news or bad?
Barclays offers no view, but a case could be made on either side. On the “good news” side, if one looks at the commodity fund as the new asset class that provides the best hedge against inflation, then it may be that investors see no need to dump this hedge. Inflation levels are still uncomfortably high around the globe, even after recent commodity price moves are factored in, meaning investments in the stock market, or even the “safe haven” of government bonds, are being undermined in real terms. If one views the current price correction as just that, and thus unsustainable, then there is little need to keep jumping in and out of what is a more macro investment.
On the “bad news” side however, what if we just haven’t yet seen the dam break? Are commodity index fund holders sweating on windows opening? Will they see triggers such as oil below US$100 as the breaking point?
It is not clear. However, I believe the former argument is the more likely one. Few disagree that commodity prices will fall further still – into oversold territory – before the world settles down again. What would be interesting is if the US were to actually go into recession. That would clip the dollar’s wings and allow commodity prices to stabilise, except for the fact that if the whole world is in recession, who is left to provide commodities demand anyway?
Having said that, it was interesting to note that China’s steel exports have once again reached record levels. Its consumption of other commodities is also yet to show any significant slowdown.
So chances are commodity prices will likely find their oversold level in the not to distant future. And then there’s gold.
Dennis Gartman has been around in the market for a long time, and he’s never before seen anything like the sudden drop in the gold price this week. “Indeed,” he notes, “we have not seen this sort of concerted, relentless selling in the precious metals since the days of the Hunt Brothers being liquidated out of their long positions back in the early 80s”.
Gartman attended the Hard Asset Conference in Las Vegas this week, and has never seen so many long faces among the “gold bugs”. “The atmosphere has been poisoned to a level we’ve not seen…ever,” he notes. But Gartman agrees that the fall in gold reflects the strength of the US dollar and the desire by many funds and investors to just get out.
He is not too keen to suggest where a bottom might be in the price just yet, being an old hand who knows the folly of standing in the path of a moving bus, as he had presumed US$750 would hold it. That has not proved to be the case, so it’s best to stand back. However, as the following chart of the leading gold ETF shows, we may have closed in on support. Throw in Gartman’s belief that the US dollar is set to turn, and it may be that the rubber band is now stretched a bit far.
The unusual thing about gold in this situation is that there is very good reason to think the precious metal should be a screaming buy. As the US government and Fed run around saving this bank and that mortgage lender, the dollar’s value base is further and further eroded. Yet the dollar has rallied because it is only a relative measure against the currencies of other economies – which are all weak.
It was also only last month that the US Mint ran out of gold coins, such was the demand around the US$800/oz level. South African dealers had the same problem, and in the meantime India has also seen a rash of buying from the jewellers.
Not in these last few days though. It seems the physical buyers have all sensibly let the bus go past as well, waiting for the opportunity to buy at much better prices if gold can stabilise.
With all of the above, it is fair to believe there is more upside for gold from this level than down. The US dollar has rallied 12.5% against the euro and as much as 20% against the Aussie, but gold has now fallen around 28% from its high.
