To a trader, there is no phrase as fraught with danger as “it’s different this time.” And yet powerful macro-economic forces have given way to an incongruous new reality where crude oil prices and the Dow peacefully co-exist at all time highs, while gasoline lags behind, and where stable employment and strong gross domestic product (GDP) growth do not keep the U.S. Dollar Index from sliding to its lowest point ever.
A once mighty dollar
In the fourth quarter of 2006, GDP in the United States was 2.1% versus 3.3% in Europe, and to many traders it was a signal that the United States' economic might was finally giving way to the euro zone, China and others. Since then, the decline of the U.S. housing market and the implosion of subprime lenders in the United States have played a pivotal role in the decline of the U.S. dollar. It also triggered tremendous third quarter losses for lenders, including $1.2 billion for Countrywide Financial and $1.6 billion for GMAC Financial Services, as well as for investment banks, including $3.6 billion for UBS and $1.3 billion for Citigroup. It also prompted the U.S. Federal Reserve Bank to cut the Fed funds rate twice in the past two months, totaling 75-basis points, bringing the overnight lending rate to 4.5%.
“The housing market is doing horribly. House prices for the month of August fell by the largest amount on record,” says Kathy Lien, chief currency analyst for FXCM. “New and existing home sales are not all that hot, and a lot of companies are warning that there are more difficult times ahead,” she says. While the United States currently has higher interest rates than Switzerland, the euro zone or Japan, their rates are expected to continue upwards, while rates in the United States are expected to head down. “The U.S. dollar is quickly becoming one of the lowest yielding currencies that we trade,” she says.
That has been enough to create speculation that the United States would slide into recession. “But the American economy didn’t actually tank,” observes Joe Trevisani, chief currency analyst for FX Solutions. “It isn’t even close to tanking. In quarters two and three, we had almost 4% growth,” he says. And yet from mid August to early November, the U.S. dollar has lost 8.2% against the euro. “These are speculative levels; not in the sense that people are trying to make money off them, although that is certainly true, but just that their view is six months down the road. And when the future doesn’t come true, you will see what we saw last year,” when after bottoming out in October, the dollar retraced 3% into January. “I wouldn’t be surprised to see that again if you get improving statistics,” he says.
Much of the market's reaction will be based on what the Federal Reserve Bank says; and in early November Fed Chairman Ben S. Bernanke said growth would slow noticeably in the fourth quarter.
Perhaps no other market has benefited as much from the weak dollar as the grains complex. At the beginning of 2006, the idea that food would become fuel changed the landscape for farmers who stole acres from wheat to plant corn to satisfy newly mandated ethanol production levels. Meanwhile in Europe, Africa and Australia, drought brought crop yields down, fueling global demand even at record prices.
“As an aggregate, you’ve got to say we’re at record highs,” says David M. Fiala, president and chief analyst for Futures One. Fiala says that because grains are a global commodity, exports will stay strong as long as the U.S. dollar stays weak. “Although prices are higher in our eyes, they are not as high to the rest of the world.” But there have been several surprises.
“Every one was pumping up ethanol and saying that corn was going to be $6. That never materialized; corn stole all those acres from soybeans this year,” says Robert Kurzatkoski, futures analyst for optionsXpress Inc. “We are talking about the largest corn carry-over in the last 25 years,” he says, and soybeans and wheat have rallied, with wheat trading past $9 per bushel and soybeans surpassing $10 per bushel.
Kurzatkoski says the only real downward pressure on wheat will come if it steals acres from cotton, which has been in a downtrend since 1982. If so, corn may end up the sleeper hit of 2008.
“It’s a highly interconnected world, but the core remains: total supply and total demand; and this could be a year where we expand total acreage,” says Jerry Gidel, analyst for North America Risk Management Services Inc. He expects continued volatility, with soybeans in a $9 to $11 per bushel range, and corn remaining at or below $4, based on as many as 4 million additional acres planted in 2008.
In the final days of October, crude oil was trading at more than $96 per barrel, an increase of almost $17 from Oct. 1, and by the time you read this story, $100 crude oil may be the new reality. To have crude oil trading at all-time highs shouldn’t be a big surprise considering the wars in Afghanistan and Iraq. And now Turkey is threatening to invade northern Iraq to dislodge Kurdish separatists and Iran seems intent on developing its nuclear weapons capability despite new economic sanctions by the United States, which have been accompanied by the Bush administration’s recent request for $88 million to fit B-1 Stealth bombers with bunker busting bombs that could presumably be used to demolish underground nuclear facilities. Also, in early September, according to reports in the Washington Post and other news sources, Israel bombed a site in Syria that had characteristics of a North Korean designed nuclear reactor.
“We are in new territory now,” opines Raymond Carbone, president of Paramount Options. “You have instability on top of strategic importance, on top of high demand, on top of limited supply. That’s why it’s different,” Carbone says, but he adds that global demand is the primary driver for this rally, citing China and India’s ability to pick up any slack in U.S. demand and the lack of new supply and refinery capacity.
Timothy Evans, energy analyst for Citi Futures Perspective, says that since crude oil posted a low pullback settlement of $69.26 on Aug. 22, the U.S. Dollar Index declined more than 5%, or about $3.60 per barrel. And because crude has rallied more than 32% in the same period, a weaker U.S. dollar is only a contributing factor.
“The primary driving force behind the rise in crude oil prices is the expansion in the open interest and volume of trading on the Nymex,” Evans says, adding that combined futures and options open interest is up 27% from a year ago, and that as of Oct. 23, September daily average volume in Nymex WTI futures was up 79% from a year ago, when side-by-side electronic trading was added. “It’s basically hot money that’s just chasing a return that is increasingly exaggerating or ignoring fundamental shifts in the underlying physical market,” he says.
Evans is skeptical that demand is continuing unabated, and says the International Energy Agency estimates oil consumption will grow 1.5% in 2007 and 2.4% in 2008, and is likely to be revised downward, especially given recent prices. For year-end, he says fair value is $65 to $70 barring any supply disruptions. “There has been quite a bit of talk of how the crude oil market is about to tighten abruptly, but in general it is better stocked with inventory than it was back in 2004 when demand really was outpacing supply,” he says.
Back in the second quarter, the idea that equity indexes would be trading near all- time highs in the fourth might have seemed outlandish considering the ripple effects of the dump the Shanghai Stock Index took in February, the credit crunch and the price of crude oil. And yet the Dow Jones Industrial Average closed at an all-time high of 14,164 on Oct. 9 and the S&P 500 peaked at 1565 that same day.
“With the dollar’s weakness, our stock market has become the new U.S. Treasury market to the world,” says Andrew W. Waldock, principal of Commodity and Derivative Advisors LLC. Rather than repatriating capital or putting it into U.S. Treasuries, where yields are dropping due to the Fed’s moves, they are pumping up the U.S. equity markets. “If you follow the flow of money, that’s what it shows,” he says, and so long as the dollar stays weak and interest rates continue to decline domestically, more global money will be drawn here. “As much bad news as is getting beaten into the market right now, we stand a better chance of upside surprises than downside surprises,” he says. He expects the Dow futures to break down to as low as 13,100 in November, but to recover quickly.
Two factors have made that possible: the percentage of GDP spent on oil, which is roughly half of what it was in 1980, and that we have not yet hit the inflation adjusted all-time high for crude oil, which may be as high as $105 or $110 per barrel. Until oil trades in there, Carbone does not expect oil prices to drag down the equity indexes. “That’s my line in the sand,” he says.
In late October, the S&P 500 futures was trading near its high of 1584.
“If things are so bad, why are we trading 25 points off the all-time highs?” asks Larry Levin, president of Secrets of Traders. “All of the stock indexes seem to be finding buyers on every pullback, and that shows stability in the market,” he says, adding that bad economic data and the credit crisis provide institutional buyers opportunities to buy on dips. Levin says the decline of the dollar has given many U.S. based corporations a competitive lift, especially to those relying on exports. “It’s not just about the U.S. anymore. U.S. based businesses are doing so much business overseas and that’s where a lot of their profits come from and people seem to be OK with that being the case.” And he remains positive based on his expectation that damage from the housing industry has been contained.
Others may say that damage simply has been masked and remains a threat. Either way, 2007 witnessed the return of equity volatility and the incredible shrinking dollar acted as an accelerant for rallies. With so many increasingly interdependent markets at price extremes and continually developing uncertainty from the evolving credit market crisis, expect volatility in commodities to remain strong in 2008.