What a difference a year makes. As we head into 2009, the trading environment is almost the inverse of this time last year when third quarter gross domestic product (GDP) was 3.8%, the dollar was weak, commodity prices were soaring and the Dow Jones Industrial Average traded to an all-time high of 14,198.10. Today, the dollar is resurgent, third quarter GDP was -0.3%, commodity prices have cratered and equities continue a massive downturn that began in January.
“You need to have a coherent perception of what you think the overall climate is on the global level so you have a framework in which to live,” says Louis B. Mendelsohn, president of Market Technologies LLC. “Are we in an inflationary environment? A deflationary environment? Is the deleveraging over?” he asks. “Those are the things you have to get a handle on. Once you have that in place, then you look at the intermarket relationships that really drive the rest of the markets.”
Inflation has been on the rise and liquidity injections in the hundreds of billions of dollars, used to bailout and prop up investment banks, insurance companies and government sponsored enterprises, including Fannie Mae and Freddie Mac, should add to inflation, but it hasn’t happened in the near term.
“Since commodity prices have come down very dramatically in recent months, inflationary fears, which were very prevalent just a couple months ago, are dissipating considerably,” says Benn Steil, senior fellow and director of international economics for the Council on Foreign Relations. He expects inflation to slow but not fall in the first quarter. “To the extent the Fed is pumping money into the economy, it is being hoarded. But that could change on a dime.” Just as quickly, the Fed could mop up that liquidity by buying back securities, he explains.
“Everything that leads to inflation is slowing,” says James O’Sullivan, economist for UBS. “Now you have commodity prices down instead of up. You have the dollar up instead of down; and broadly, domestic cost pressures are fading as unemployment goes up and wage pressures fade.” Those factors could lead to deflation if the recession is long enough or deep enough, but he says the economy likely will respond to the stimulus and he is not anticipating deflation to take hold. Rather, the United States is currently in a state of ‘disinflation,’ which he defines as a recession with slowing but not yet negative inflation.
Craig Weil, independent floor trader and director of trading at Online Trading Academy, agrees that deflation is unlikely, adding the wage deflation we are currently experiencing is mostly a reflection of globalization rather than rampant U.S. unemployment. “I would lean toward a stagflation scenario,” where commodity prices and some of the currencies rebound, while the economy demonstrates no growth. “In stagflation you would be long gold and agricultural products and there would also be some equity sectors that you want a position in as well,” he says.
Cash money rules
Commodities and other U.S. dollar-denominated assets have crashed in recent months as the dollar has strengthened (see “Reflecting badly,” right). That the dollar has strengthened, despite eroding fundamentals in the U.S. economy, is largely due to the massive deleveraging prompted by the credit crisis, the demise of the investment banks and the stock market crash.
“Everybody is hoarding their cash,” says Darren Dohme, VP of OTC trading at RJ O’Brien. “Individuals want out of mutual funds; hedge funds want out and to bring cash home. That’s why the dollar is rallying. They want to put it in T-bills and T-bonds and bring it home from other countries, so they have to turn it into dollars.”
In the near term, the dollar is likely to continue strengthening relative to the euro, Mendelsohn says, because the European Central Bank has been slow to respond to a slowing economy and credit crisis and likely has as many or more problems than the United States. “Longer term, the U.S. dollar is going to have to weaken,” he says, given the massive amounts of stimulus injected into the U.S. financial system and the cost of that debt service. “It’s going to end up being $500 billion per year. That’s not sustainable. So the U.S. dollar is going to weaken, probably some time in 2010.” He says that if commodity markets, and gold in particular, hold their current levels, the dollar could strengthen further into the first quarter. Then commodities likely would drop another 10%.
When institutional traders experience heightened liquidity preference, they use Treasuries as a surrogate for money, Steil explains. “You can say it doesn’t pay much interest, it’s gone down to about 0.2% interest at various points in time, but that is better than holding a dollar under your mattress.” However, as the Interbank credit freeze thaws, and it is thawing slowly, Treasury prices will begin to fall, which will precipitate a decline in the dollar. “The dollar is at risk of a very significant fall because of the interest rate differential between the euro zone and the United States,” he says.
In times of economic uncertainty and throughout history, gold is money. The fact that it has instead been languishing with other commodities is a function of the dollar’s recent exaggerated strength and may be a buying opportunity. The onset of inflation and weakening U.S. dollar would be a boon for gold prices.
Joe P. Marshall, trader/analyst for Pitguru.com, says that despite gold declining to $700 per ounce from $900, gold prices are still elevated from a long-term perspective. “In 1999 it was $350 an ounce, in the big picture, that’s not all that long ago,” he says. In the first quarter of 2009, Marshall says gold will hit $1,000 per ounce and stay there after a series of higher lows. “When it sells off, it’s not going to head to the previous lows. It’s going to be a ladder going up.” Silver and crude oil should also follow that same pattern, he adds.
“When you look at gold, you have to look at crude,” explains William Adams, managing director of JKV Global. “Crude is really valued in gold; the price of crude is usually one-tenth the price of gold. December gold is trading at $771, and we have December crude, which is roughly $71 per barrel.” As speculative interest flees the markets, Adams expects more buyers and sellers with actual cash risk to reassert control over the commodity markets and for such parity relationships to come back in line.
Fuel and food
On July 11, 2008, crude oil traded to an all-time high of $147.27 per barrel, but it closed at $65.96 on Oct. 30, a stunning fall prompted by the dollar lifting its head off the mat and a massive decline in consumption as the global economy hit the brakes. While OPEC is busy cutting production to put a floor under oil prices, Americans are breathing a sigh of relief as gasoline prices head down to $3 per gallon. But volatility remains very high, and if the dollar drops, inflation returns or the global recession proves shallow, the energy markets could turn up.
“Even though they are grotesquely off their highs, from 2003 to 2005 they never traded as high as they are currently,” says Gavin Maguire, director of EHedger LLC. “Crude oil is not being cracked for gasoline right now because of low gasoline demand, but it is for heating oil. And so, if we have a cold winter, heating oil and natural gas will be pushing higher from current levels. If this is the floor, we need to get used to higher heating bills.”
Gasoline futures are currently trading at $1.40 per gallon, Dohme says, and you want to own it for the 2009 summer driving season. “Gasoline has got to be the hot market for 2009. It has had the biggest break of any commodity out there.” The crack spreads are negative and ending stocks are within the five-year average. “Refineries are running on such thin margins here, they are not going to build their stocks properly and gasoline is going to look downright cheap for next summer.” The same can’t be said of ethanol, which is now more expensive than gas, leaving refiners with no incentive to blend the fuels. “That tells me we are going to take 2 million to 3 million bushels away from corn demand. There is no reason for corn to rally,” Dohme says.
Because of the correlation between energy and fertilizer prices, lower energy prices could mean better margins for corn farmers; and higher energy prices mean higher grain prices. Despite the economic slowdown, Adams says grains will be among the better performers as spring approaches. “I am still going to drive my car and eat dinner every night, and those are realities that affect the economy,” he says. Despite the disparity in gasoline and ethanol prices, solid corn production and a 51¢ ethanol subsidy will keep refiners interested in blending the fuels, he says. Other positives for energy and grain markets are electronic trading, extended trading hours and the ability to handle institutional size trading, he says. “Energies are one of the few markets that can handle the volume that equities could. They can really swallow a lot of contracts over a long period. And, based on the world’s need for energy, it provides a really good hedge against inflation as well as everything else that ails the economy.”
Signs of life
There are two sides to every trade and it follows that every sector continues to offer great trading opportunities, provided that liquidity isn’t frightened off by this heightened volatility. In 2009, markets that have found their bottoms and have inelastic demand curves should provide opportunities to get long. In addition to reliably maintaining worth, the dollar, crude oil and gold also will provide technical cues as to the health of the global economy and indicate other emerging trading opportunities.
Also watch for the stock markets to bottom out. O’Sullivan says that recessions typically have ended within three to five months after equities have found the bottom (see “Trough,” page 23). At that point, inflation could reappear and reignite commodity markets. Until then, watch for signs of life. As sudden as the declines have been, the recovery will be long.
“Fear is going to rule the day for the foreseeable future, but that doesn’t mean we are not on the backside of the storm,” Weil says. “I have a trading mentality. I let the markets tell me where to go and I am not going to get married to any particular product.”