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What does a Commodities Bust mean for the U.S. Dollar? Not what you’d think…

June 1, 2011 4 comments

PSI

We could see the start of a commodity meltdown tonight.  The oil market is extraordinarily fragile right now, and commodities are not looking healthy at all.

Of course you’re paying attention to the price of Silver, Gold, and Oil.  It’s impossible to fill your gas tank without noticing the huge hit to the wallet.  And Silver has been just going crazy until just a few weeks ago.

There is a huge clamor from people who don’t know how money works that the weakness of the U.S. Dollar is due to the actions of the Federal Reserve.  Zero Hedge is just one of the nuttiest, but you can find this claptrap everywhere.

It’s undoubtedly the wrong model, but it is the dominant model.

The conventional wisdom model in a paragraph: Quantitative Easing is – must be – shredding the value of the U.S. Dollar.  As proof of this astonishing, irresponsible behavior, Commodities are prudently rallying, because commodities are iron clad protection against the inflation that is certainly just around the corner.  Commodities are not in a bubble, their dramatic increase in price is a rational response to a near-worthless U.S. Dollar.  Other Currencies – the euro, Swiss franc, and Australian dollar, are also rallying because of the irresponsible fed.

It’s a convincing argument when commodities are in rally mode.  But Commodities are no longer in rally mode.  We could be seeing the start of the crumble right now, tonight.

In the last few weeks, Silver took a serious tumble.  A 20%+ drop in 3 days is a huge move for any market.  Not only that, but Silver could be forming a “flag” – a technical formation that predicts a further huge decrease in price.  This isn’t guaranteed – but it is something to watch.

People are beginning to question if Commodities will last.  Perhaps commodities are in a bubble.  We have had enough bubbles in the last few years – why not Commodities?

There is ample evidence that Commodities have a large speculative bid.

I focus on oil and copper because these two commodities only make sense to buy them if you are going to use them.  If the reason Copper is going through the roof is to prop up what appears to be a massive credit bubble in China, then we need to monitor signs the Chinese Government is cracking down on the practice.

And it appears China is cracking down on the Copper financing practice.  In a few months, this source of financing will go away for Chinese companies and speculators.  It appears that China has several years worth of Copper imports sitting on the ground being used as a way to borrow money very cheaply.

It makes sense to ask what would happen to the U.S. Dollar if there is a significant correction in the Commodities market.

Would a correction in the Commodities market be a bullish sign for the U.S. Dollar? 

The selloff in Silver could be the trigger event that causes a massive selloff in the entire commodities complex. It could cause a total rethink of the market consensus.

We are seeing this in price action today with oil going down, the Euro holding steady, and Swiss franc going through the roof. Commodities are correcting across the board, but the Currency markets are mixed.

If the commodities sell off, the primary proof the U.S. Federal Reserve is out of control will be far less potent. So what happens to the U.S. Dollar?

The conventional wisdom is that the U.S. Dollar must become stronger if commodities become weaker.  I am not as convinced about the link between the weak U.S. Dollar and the large increases in Commodity prices.

This is not to say there is no link between Commodities and the U.S. Dollar. If Commodities enter a correction, the U.S. Dollar could rally at least some.

Still, two data points give me pause:

  • U.S. Dollar Index and Commodity index out of sync over last decade
  • Massive speculation in Commodities covers up moderate real demand

The U.S. Dollar is roughly 8% weaker than it was in late 2005. In December of 2005, the U.S. Dollar index hit 80, vs. a price of 73.10 today. However, the CRB index is 130% higher than it was at the end of 2005.  You’d think that when the U.S. Dollar lost a ton of value, the CRB would have risen a proportionate amount.  It didn’t.  The spectacular rise in the Commodities came long after the U.S. Dollar had its most dramatic losses.

I’ve created a model of currency valuations based on the principles of MMT.  The model says the EURUSD should be much higher than it is today – perhaps as much as 20% higher.  I have kept the last few years of data of this model to myself.

But why am I talking about this?  Because if the Commodities fall but currencies rally, the conventional narrative cannot be true. But some other narrative must be. MMT provides a narrative that accommodates Commodities going down and the USD going down.  

The MMT narrative about the Commodity rally is that it is nearly all speculation based.   Warren Mosler says much of it is due to the huge inflows into long only commodity funds.  I agree with this narrative.  But MMT does not have a currency model – at least not a public one.  😉  I do have a model, based on MMT, that says most currencies around the world have a reason to be stronger against the USD.

Even the pathetic Euro – that messed up, fatally flawed currency – has a powerful reason to rally against the USD.    

This blog is called the Traders Crucible, after all.  Some forms of fundamental trading are applied economics.  Fundamentals of the currency markets fall into that category.

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