U.S. Dollar Strength or Oil Weakness?

Is it U.S. dollar strength or oil weakness? The greenback is strutting its stuff over the last few weeks, up nearly six percent against the euro. And the Aussie dollar, which had been within an eyelash of reaching parity, has since declined to eighty cents against Team America's currency.

Does it matter? Well, sort of. For reasons explained in this space ad nauseam, the U.S. dollar isn't fundamentally strong. But relatively speaking, it might look less weak than it used to.

That is, traders are beginning to think that the slump that hit the U.S. first has now spread globally. The U.S. bore the brunt of the growth-slowing, credit-crisis-induced correction. Now it's the rest of the world's turn to suffer.

That is one way to explain the U.S. dollar's recent action. And don't forget what OPEC President Chakib Khelil said in late April. He told investors that, "[Oil] prices are high due to the fact of the recession in the United States and the economic crisis which has touched several countries, a situation which has an effect on the devaluation of the dollar, and therefore each time the dollar falls one percent, the price of the barrel rises by $4, and of course vice versa."

Pencils and papers please. A six percent decline in the U.S. dollar against the euro should translate into a $24 decline in oil prices, according to the Khelil's math. Oil would be at around $123 if the dollar rally began exactly when the oil price began to fall. It doesn't quite synch up like that. But you get the impression the Sheik is on to something.

Don't forget leverage either. The relative rise in the dollar leads to lower commodity prices. But falling prices also cause traders to cash in their long commodities trades. This additional selling accounts for the even bigger than expected falls in some specific sectors (like base metals).

What does it all mean? The U.S. dollar may look less ugly relative to the euro than it did a month ago, given the prospect of slower growth in Europe. But what an ugly piece of trash it remains. We have no idea how long the rally will last or how much lower resource prices will go. But we are nearly certain that by the end of the year, the dollar will resume its passage on the way toward intrinsic value, which is much lower than today's current value.

Dan Denning
The Daily Reckoning Australia

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