Commodities and the End of QE


As boring as it sounds, I’m going to talk a bit about the end of QE today. Because it’s very important to how markets are going to behave over the next few months.

As you probably know, overnight the US Federal Reserve voted to end its policy of quantitative easing. But it will still be reinvesting the interest payments from its $4 trillion plus portfolio and rolling over any maturing treasury securities, so it’s balance sheet will continue to grow, albeit much more slowly.

On the surface, US markets didn’t seem too fussed about the end of an era. Shares sold off around the time of the Fed’s statement and then rallied towards the close. Probably a case of ‘algo’s going wild’ as automated high frequency traders tried to make sense of the Fed’s statement.

And the Fed did its usual job of promising to hold rates as low as they possibly could, which markets seemed happy enough with.

But the real action took place under the surface. That is, the US dollar spiked higher again, as you can see in the chart below. This is an important point because when the US dollar rallies, it usually signifies tightening global liquidity.

Think of it as liquidity returning to the source (US capital markets) and drying up…or disappearing. That’s certainly what has been happening these past few months. Since bottoming in May, the US dollar index (which measures the greenback’s performance against a basket of currencies) has increased by nearly 9%.

King dollar in a bull market

That might not sound like a huge spike, but in the world of currency movements, it is. Imagine if you’re an exporter and your product just became 9% more expensive…chances are it will lead to a drop in sales as customers look for a cheaper substitute.

This is the problem with the end of QE. It leads to liquidity evaporation as ‘punt money’ returns home…which leads to a strengthening US dollar…which hurts sales of US multinationals.

It’s not going to happen right away though. Most companies have hedging strategies in place that protect them from sharp moves in the FX markets. But if dollar strength persists…and the chart above says that it will, then you’ll see the strong dollar hitting companies’ revenue line in the coming quarterly reports.

Not only that, but the evaporation of liquidity in general could lead to another bout of selling across global markets. QE is all about providing confidence. Liquidity is synonymous with confidence. Take it away and you’ll see the mood of the market change.

Getting back to the dollar strength…it’s a headache for Australia too. It’s smashing the iron ore price, and the Aussie dollar isn’t falling fast enough to keep up. In terms of the other commodities though, things aren’t quite so bad.

All you seem to hear lately is negative news about commodities. That’s because the world prices commodities in US dollars, and as you’ve seen, the US dollar is a picture of strength. But if you look at commodity prices in terms of Aussie dollars, things look a little better.

The chart below shows the CRB commodity index, denominated in Australian dollars. It’s a weekly chart over the past five years. And y’know what…it doesn’t look that bad! Since bottoming in 2012, it’s made considerable progress in heading back to the 2011 highs.

But you’ll want to see it start to bottom around these levels. If it doesn’t, prices could head much lower.

Commodities in Aussie dollars — not too bad!

The thing to note about this chart is that it doesn’t include the bulk commodities — iron ore and coal. These commodities tend to dominate the headlines in Australia. Things like nickel, tin, copper and oil don’t get much of a look in.

Which reminds me, in case you missed it, Diggers and Drillers analyst Jason Stevenson recently released a report on some small Aussie oil ‘wildcatters’. With the oil price low, now could be a good time to sniff around the sector.

You could say that about commodities across the board. In the space of a few years, they’ve gone from hero to zero…or the penthouse to the…

That usually means there could be some good value around. One thing you need to look for in the current environment is a decent demand/supply dynamic. Iron ore in particular is heading towards massive oversupply next year. I reckon that makes it a poor investment choice for the next few years.

You’re better off to wait until the China slowdown and supply surge knocks out the juniors and all the marginal producers….leaving the market to BHP and Rio. You’ll then probably be able to pick these mining giants up at much lower levels.

Once you find a commodity with good supply/demand fundamentals, you need to make sure the producer is low cost. That protects it against further price falls…or a rise in the Australian dollar.

It also protects it against foreign competition. One of the issues with the Aussie resources sector in recent years is costs. Other countries have much cheaper capital and labour costs and can therefore get stuff out of the ground cheaper than us.

That brings me to a final issue: Australia doesn’t really invest in its own resource sector. Via superannuation, we have a huge pool of capital. But this mostly goes into the banks or the major miners. Superannuation capital is not high risk capital.

That means a lot of the capital that flows into the resource sector is foreign. And when global financial conditions change…like the end of QE and the strengthening of the US dollar…that capital departs.

This will create problems and opportunities for the sector. But given the bearishness towards commodities in general, it’s probably time to start getting interested again.

Greg Canavan+
For The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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1 year 11 months ago

Bankers can only provide fiat currencies which, history has proved over and over, inevitably collapse.
Currencies are not money. It is energy that creates money. Money can not create energy.
Peak oil mates, peak oil. Depopulate or perish.

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