Thursday, January 15, 2015

Commodities Lead and the Dollar Follows

The US dollar (in broad trade-terms) has been acting weird lately, and by lately I mean since early 2011. Going back to the turn of the millennium (15 years ago), the tech bubble burst and there was a lot of speculative money that found itself without a purpose. Going back even further, the US focal shift from manufacturing to tech-based services during the 1980s and 1990s, saw raw materials ignored for computer-based research, development, and production as an investment theme. Speculative investment capital flowed in particular out of commodities and commodity exporting currencies.

The 20-year trend officially reversed in 2002, aided by the Fed's easy monetary policy in response to the recession associated with the September 11th attach. The liquidity made available by the Federal Reserve system accomplished two things; the housing market inflated with speculative capital flows, and globalization-driven growth in emerging and developing markets attracted dollar denominated investment flows. As dollars got to their foreign destinations, they had to be sold to acquire local currency. The foreign-financed growth fueled new demand for raw materials, and supported commodity prices and commodity exporting currencies.


From 2002 through to 2008, commodity prices trended higher as the dollar trended lower, representing an expanding appetite for risk by international investors. Then the Global Financial Crisis hit, and the reflex reaction of investors around the world was to find safety at all costs. Almost all risk-assets saw a tumble in prices, as short-term US-government debt was bought en masse for its apparent safety and liquidity. Commodity prices, not to be excluded, also fell. Once the financial markets stabilized in 2009 with a monetary commitment from the Fed and other central banks, the trends seen in commodity prices and the dollar from 2002 resumed.

In April of 2011 (as reported by the Federal Reserve Bank of Atlanta), commodity prices peaked. At that point it was becoming clear to investors that the long-term trajectory of global growth was shifting lower, and the demand for raw materials would be depressed, at least for the immediate future. The Fed however, did not incorporate this view into monetary policy until later the following year, when they announced the third round of quantitative easing. This was viewed as final confirmation that slower global growth would hamper the US recovery, and by virtue, perpetuate slower global growth, and so the dollar once again started appreciating as commodity prices continued to slide.

The relationship between the US dollar and commodity prices has been, and continues to drive macro cycles in the global economy. From a fundamental basis, the dollar's appreciation is driven by uncertainty. As the customer of first and last resort, global economic strength and stability resides with the United States. Yet, the US depends just as much on its trading partners for growth as they do on the US. In this age of uncertainty, one thing is fairly certain; the global economy is underperforming its long-term potential. So while everyone waits for a new (lower) equilibrium to be reached, from which point the global growth outlook can improve, the US dollar will remain the safest bet.

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