U.S. Dollar Rally Not Based on Fundamentals

"Commodities fell the most in six weeks as a rally in the dollar eroded demand for energy, metals, crops and livestock as alternative investments," reports Bloomberg. We take issue not with the facts-commodity prices have fallen-but with the analysis.

The price of energy, metals, crops, and livestock are rising because the supply of those things is rising less fast than the supply of dollars (and U.S. government debt). The Bloomberg analysis casually suggests that investors rotate their portfolios out of greenbacks and into herds of Black Angus...and then back again when confidence in the dollar returns.

Inflation, though, begins with the money supply. We reckon that as long as it remains the strategy of the U.S. government to inflate away its long-term debts, commodity prices will rise and the dollar will move lower toward its intrinsic worth.

Nothing fundamental explains the U.S. dollar's recent show of strength. The difference in interest rates is surely not driving the dollar rally (unless you believe the Fed is done cutting rates and the ECB will soon begin). U.S. rates, adjusted for inflation, are negative. And it's certainly not U.S economic growth driving the buck. While the Saudis ride the increase in the oil price to 5% annual growth, America is barely growing at 0.6% in the first quarter, if the official GDP figures are to be believed.

So why did the dollar rally? The dollar's strength is only relative. Part of its rally could be short-covering by the many traders who've been short the currency. Part of it could be that investors believe the Fed will not be cutting rates and weakening the dollar any more (at least not until the next crisis hits).

But most of the move is just noise, we reckon. In the greater monetary scheme of things, the dollar is not getting any more attractive. Commodity investors should be prepared for these periods of doubt, uncertainty, and profit taking. Less resolute investors will be shaken out by these corrections.

As we said in an interview about gold recently, there is still big money to be made in precious metals. The easy money has probably been made. But the bigger money will come when the credit rating of the U.S. government goes below investment grade and the government begins defaulting on its obligations.

For the first time ever, the fixed rate on U.S. inflation-indexed bonds (TIPS) is now, get this, zero. TIPS are indexed for inflation, giving investors the fixed rate plus inflation. But with the fixed rate now at zero, investors are getting nothing, and probably not liking it.

About the only thing you'd get back for investing in TIPS is your capital. These days, perhaps the return OF capital is more important than the return ON capital.

Speaking of which, what about yesterday's question? Would you buy equity in Citigroup or bonds issued by Petrobras yielding about 5% with a six-year maturity? The reader response was both muted and divided.

"i'm not that much of a gambler i'll stick with the bank......i can sleep and i can plan !!!!!!!!!!!!!"

Okay!!!!!

"Six years could be just the start of a long relationship of great maturity and depth. But long for my time-line. Will the bonds be denominated in Reals or other commodity currency?"

Good question. Brazil's currency is getting stronger. The dollar, not so much. Earlier this week, S&P raised the credit rating on Brazil's dollar-denominated bonds from BB+ to BBB-. You can take that for what it's worth (the value of S&P's rating). But Brazil's stock market is roaring. Brazil is the Australia of South America, you could say.

Our choice? We'd probably stay in cash, being quite conservative. But if forced to choose...we would note that Citigroup has raised some US$40 billion in capital in the last six months...and US$10.5 alone in the last two weeks. Every time the bank says it has enough capital, it ends up asking for more.

Even assuming the bank can recapitalise and stabilise itself, where will the earnings come from? Will the share price rally because the banks assets will suddenly be worth more?

Petrobras faces some big challenges in actually producing oil off-shore. But at least it knows the oil is there. We'd go with Petrobras.

A quick follow up on Exxon. The company reported a tidy US$10.9 billion in first quarter net income yesterday. Revenues were up 34% to US$116.9 billion (for the quarter). But we note two items that might have XOM directors scratching their heads.

First, oil and gas production actually fell in the quarter by 5.6%. As good as the revenue performance was, it could have been ever better had XOM produced more oil and gas. It's getting hard to produce a lot of oil and gas these days, and to replace what you've produced.

Second, XOM lost money in its refinery operations to the tune of US$5 million per day in the quarter. As we pointed out last week, the company pays wholesale prices for crude but retails the refined the products. Prices in the wholesale market for crude have risen more than prices at the pump.

Margins go "crunch." No wonder Exxon isn't interested in building any more refineries in the U.S. The company does plan to spend US$25 billion on new upstream production. Downstream be damned. And gee...isn't that a much better use of $25 billion than whatever Citibank is doing with its $40billion?

Inflation, oil, and dollar debates aside, the direction of U.S. financial markets comes down to the direction of the U.S. housing market. Bill Gross at PIIMCO explains that house prices are critical because they are, "at the forefront of potential asset deflation."

"Because the U.S. and selected other economies are now substantially asset-based and dependent on stable and upward tilting prices, a deflation of an economy's primary financial asset can be ruinous. Its deflationary thrust must be countered, wrote [Hyman] Minsky, or else the battle might be lost."

Housing is America's primary financial asset. If it continues to deflate, there's no doubt the effects will be felt in the real economy. "A continued housing deflation of several trillion more dollars now threatens to impact the real economy which in turn might produce a reversal of financial market fortunes," Gross explains.

This is all dire news for American investors and consumers. It seems less dire, viewed her from Melbourne. Australia is buzzing with investment opportunity in energy and mining. Housing assets are important at the household level. But with labour markets and business spending geared to the resource market, the Aussie economy enjoys asset-based inflation in commodities in a way the U.S. market does not.

We wouldn't exactly call that a perfect decoupling. America is, after all, the world's largest economy. But more than two thirds of American GDP is based on consumption. It's likely that a few trillion dollars worth of housing values wiped off the national balance sheet is going to wipe a lot of money off of U.S. GDP.

This, of course, gets to the heart of the myth of consumer driven growth that infects much of the economic thinking in the Western world. More choice and lower prices are great benefits of globalisation. But real wealth is only added to when people make things and sell them.

You can buy plenty of things once you're rich. But you can't get rich buying things. Great economies are built on production, not consumption.

The higher quality the production (better engineering and technology) the greater the profit margins. But we have all been duped into believing that service-based economies are the future. If they are, it's going to be a very grim future indeed, at least for people whose financial lives are hostage to events beyond their control.

For those of us who aren't Ben Bernanke and Glenn Stevens, much of what happens in the financial world IS completely beyond our control. All we can really control is our analysis of what's going on and what to do about it, or how to prepare for what we think is coming. More on likely and unlikely financial catastrophes next week. Have a great weekend...

Dan Denning
The Daily Reckoning Australia

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