U.S. Dollar Index Showing All Sorts of Weakness

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The U.S. dollar taketh…and the U.S. dollar giveth away. That’s one way of looking at the flurry of activity in markets right now. The Aussie dollar is at a ten-month high. Oil is up 75% since January, with crude trading at $74/barrel. Copper is at a ten-month high. The S&P 500 has cracked 1,000 again.

Meanwhile, the U.S. dollar index is showing all sorts of weakness. The chart below tells you a couple of things. First, you can see that when the short-term moving averages cross the longer-term moving averages, it usually signals a move. We’re not making this up, by the way. We asked technician Gabriel Andre why the crossing of the 50-day MA over the 200-day MA was significant. His answer below.

“Is it sort of like Ghostbusters, where you’re not supposed to cross the stream,” we asked?

“No.”

“Okay, please explain.”

“Yes. The shorter-term price action has more weight. When the 50-day crosses the 200-day on the upside, it’s bullish, as your chart shows. Conversely, when it crosses the 200-day in a negative direction, as your chart also shows.”

“What happens when the longer-term moving average moves down too?”

“When it rolls over?”

“Is that what it’s doing?”

“Perhaps. You would have to look at a longer-term chart. But this one indicates dollar weakness, which is showing up in Aussie dollar strength and a rise across the commodity sector. The prices are all relative to the weaker dollar.”

Ah yes, the world of relative pricing. We admit we approach the technical explanations of market movements with a great deal of trepidation. The belief among the chartists and the technicians is that all the relevant information about an asset – it’s past, present, and future – show up in the chart. You just have to learn how to read the chart, which is admittedly more of an art than a science (in our opinion).

Nonetheless, the chart of the dollar index is consistent with our own fundamental diagnosis of the dollar’s weakness. Big fiscal deficits, massive unfunded social liabilities, low interest rate, a labour market facing lower structural wages and more service sector jobs, an increasingly reliance on government transfer payments, and higher taxes in the offing to pay for government-sponsored health insurance …these are all bad signs for America’s economy and its currency.

And by contrast, Australia looks downright bullish. So bullish, in fact, it appears to have cheered up Dr. Doom himself. Nouriel Roubini was in Kalgoorlie yesterday at the Diggers and Dealers conference signing Australia’s resource praises. “As the global economy goes toward growth as opposed to recession, you are going to see further increases in commodity prices especially next year,” he said.

Those commodity price increases – and the earnings that Aussie firms will generate from them – are what investors are queuing up for right now. It’s what’s sending stocks higher. But is it real growth or phantom growth?

We know that China is the world’s biggest metals consumer. And we know that China’s GDP grew in the second quarter at 7.9% and we know that China is spending hundreds of billions of dollars to keep its economy ticking over, employment full, and metals fully stock piled.

But what we don’t know is if the world’s economy has really reached the bottom of this debt-deflation cycle, where the bad investments and underperforming assets of the credit boom are written down, or off altogether. Is the balance sheet recession – the reduction of debt and the write down in assets bought with debt – really over?

That’s the question. We’d suggest the answer is no. But then, it doesn’t pay to argue with markets does it? The wretched performance of the U.S. dollar and dollar-denominated bonds leaves investors with a simple choice: speculate on other, riskier assets, or watch the value of your dollar-based savings erode.

So we have the era of forced speculation. It’s a kind of dollar exodus. And anything that is not the dollar is a potential promised land. The upside – if you own oil, base metal, and commodity shares – is that there’s a strong tailwind behind your investments.

The downside is that the speculation may not be based on real sustainable growth. It’s just another lending bubble in China piled on the rubble of the real estate lending bubble in America. Bubbles built on rubble aren’t stable. That means you may be better of trading the shares, rather than buying and holding and getting whipsawed by volatility. It’s worth thinking about.

Not that we’re complaining that shares are rising. But it’s important to distinguish between a genuine bottom in the cycle and an epi-cycle, a mini asset boom in the middle of a broader bust (which is what we think this phase is). If it’s one and not the other, your investment strategy and trading tactics would change.

The only real reason to whinge about it, from a value investor’s perspective, is that it makes it harder to find under-bought bargains. Dirt cheap valuations and laggards are harder to find when a liquidity boom drives up all stocks. With so much cash coming in from the sidelines, it sure looks like a liquidity driven rally.

One asset that’s especially confusing is oil. It’s benefitting from its “not-the-dollar” status. But there are also, we believe, some fundamental reasons to like oil and energy stocks.

According to a recent article in Britain’s Independent, “The world is heading for a catastrophic energy crunch that could cripple a global economic recovery because most of the major oil fields in the world have passed their peak production.”

The report quotes Dr. Faith Birol, the chief economist at the International Energy Agency (IEA). Dr. Birol told the Independent that, “global production is likely to peak in about 10 years-at least a decade earlier than most governments had expected.”

The IEA provided a detailed assessment of 800 major world oil fields. Those fields account for more than 75% of the world’s proven oil reserves. The IEA concludes that that production at most of the biggest fields has already peaked and that, “the rate of decline in oil production is not running at nearly twice the pace as calculated just two years ago.”

“On top of this,” the Independent reports, “there is the problem of chronic underinvestment by oil producing countries, a feature that is set to result in an ‘oil crunch’ within the next five years.”

Back in March we reckoned this underinvestment was going to lead to a spike in oil prices. There was the little matter of the super-contango in the oil futures market, where the futures price for oil was, briefly, nearly four times the spot price. This indicated that speculators and traders were betting on much higher oil prices later this year.

Since then, the futures price has declined a bit as the global economy proved more resistant to fiscal stimulus than first expected. But the spot price has soared. The contango has narrowed. But the net result is that oil is much higher. So what now?

The trouble with forced speculation is that it makes all asset prices more volatile. They are less driven by supply and demand and more driven by relative movements in other asset prices (currencies and bonds). But with oil, we prefer to keep our eye on the long-term supply picture. Why?

Barring a total collapse in industrial civilisation, it’s safe to assume demand growth for oil will resume. You may not know when. But you know it will happen eventually.

Supply growth is a whole different mammal. Not only does the IEA report show that production at the world’s major fields is declining faster than expected, it shows that traditional oil exporters are exporting less and consuming more of their own exports. When you combine those two factors with a resumption in demand growth – it leaves countries like Australia on the outside looking in.

Exporters are producing less and exporting less (at least that’s the trend). And Australia must compete with large consumers like the U.S., India, China and Japan. Not a pretty position to be in. But for investors, it’s not a nightmare either. The junior oil patch is heating up.

What about the rest of the market? Chart Partners Group Ltd. tells Bloomberg that the S&P/ASX 200 could plunge by as much as 19% in the next three months. It reckons the index will peak at 4,300 (about 1% up from here) and then hit 3,500 by October.

Keep in mind the whole thing is up 35% from a five-year low in March. A correction would be in order. But as reading the chart is not our game, we’re going to get Swarm Trader Gabriel Andre on the case and report back to you tomorrow on what he says. Until then…

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. So many of Dan’s comments match my recent thoughts that I can concentrate on the variances without too many anecdotes needed to support his line.

    One supporting comment on the medium term global oil & gas supply glut that Caplan of Shell Aust was alarmist about in recent days melds with the imperative the US and Brits and Dutch and more recently the French are putting behind the Afghanistan campaign and their oil companies search for the Turkmenistan pipeline access. So much so that the Bush US started courting the Indians making us look politically stupid with uranium & non proliferation (look the other ways) in exchange for the alternate (to Pak) pipeline route to the Indian Ocean worked out with Karzai and the Indians growing cuddle ups. Poor old Pashtun and Pak now get nothing but corpses if they lose so we are likely to see a far bigger mess in coming months. I also reckon Abdullah Abdullah might reach power over Karzai because the US CFR hardliners are behind him.

    My variances to Dan are in his views of the prospect of a “lending bubble in China”. The lending bubble in my view of the recent spurt is coming from the same old same old. It is USD colonialist investment made by US merchant bank market makers and hedge funds and the source in my view is new funny money. The Fed has become this cycle’s ratings agency self interest driven fraudsters. They have exchanged rubbish securities as good and allowed the banks to generate new funny money capital leveraged on the old that was never marked to market. The merchant banks are going to rip out profits short term in foreign markets until they decide they can’t hide any more from excess inventories any more and then they will a mass run the other way with short positions.

    The questions you have to ask and proof to obtain to cut down my argument would be in the application of lending funds by the US banking sector. My view is that people aren’t taking heavy bets on equities dependent on the US economy or US domestic asset prices.

    The last thing I want to highlight is the spin around the terms “risk asset markets” and the “safe haven”. In my view the safe haven is “the redemption panic run”. So when the speculators funny money meets inventory reality it runs not to safety but to the redemption for leveraged investors facing the equivalent of margin loans or capital calls. The only thing “risk asset or commodity markets have to fear are the short term panic retreats of the funny money and that gives us a field we can play in on our markets. How the major AU banks fit this equation and have been capturing this recent funny money more successfully than even commodities I haven’t yet figured out.

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  2. Will the (USDX) bounce or will it fall to next resistance areas around 76 and 72. Apparently there are no longer markets now, only interventions.

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  3. Oil is a good inflation hedge if US$ inflation is moderate, but there are limits on how much inflation it can hedge against.

    Too much inflation in the US dollar will put a cap on oil price rises.

    Oil is essential, but the US economy is already desperately weak. It would be devastated if oil rises to US$150/barrel again. That would cause demand destruction as the US economy falls off another cliff… which no doubt would cause more weakness around the world, thus pushing the supply/demand equation back towards excess supply.

    How poetic that oil will cause the world economy to splutter.

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  4. Correction. Should be, “There is no longer any free market, only interventions”…. or something to that effect. Forgotten who said it. My point is, that despite the obvious in long term trends the short term trends are hard to bank on in a heavily manipulated environment.

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  5. xoc, I agree with your point. It isn’t only inventory reporting events that could turn the market, mark-to-market discipline finally being brought to bear (real deleveraging instead of pass the parcel or extend the parcel), or a steep jump in interest rates affecting both debt service costs and demand at the same time would inevitably be the path to that excess inventory scenario as you explain. A focus event for me is the 1 January 2010 FASB rule change that is supposedly sufficient to finally rein in the off balance sheet chicanery.

    There is however nothing that will fix the fed’s balance sheet quality and the leveraging curve at household level that fed US GDP won’t come back any time soon surely. And recent current account deficit country household savings isn’t capital creating saving, it is household debt servicing and paying off principal off a too small sector of good loans that are already booked as assets and where the resulting lending capital was extracted long ago.

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