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October 06, 2005

Commodity Currency Action Makes Sense
by Chip Hanlon

Looking at the action in the commodity currencies (particularly those of Australia and Canada), the drubbing they're taking today (Tuesday, 10/5/05) makes some sense, but only if you're looking at things a certain way.

Truth is, it's a really complex environment right now. Aside from the arrogant few who constantly spout the same tired dogma, a lot of very smart analysts are perplexed by the way commodities, currencies and other asset classes have recently been trading in relation to one another. Meanwhile, nobody has gotten this year exactly right. While I can pat myself on the back for doing an about-face on the U.S. Dollar almost on its bottom tick last December, even as a precious metals bull I didn't also make the call that gold would rally so strongly despite a rising Greenback. And while others have been quite right about commodities and commodities-related markets, those types didn't envision the drubbing the Euro, Yen and Pound have taken this year.

Assets just aren't trading in the groupings we had all gotten used to from 2002 through 2004.

Things do add up a little better, though, if you believe the global economy is still U.S. centric (or U.S.consumer-centric), perhaps now more than ever. As I suggested in a brief article on September 14th, I believe the action of global stock markets over the last few years supports such a hypothesis.

Perhaps the biggest surprises in 2005 thus far have been these:

1. The resiliency of the American economy and
2. The resolve of the Federal Reserve in tightening interest rates

Now, one could certainly complain about the imbalanced nature of our inflation-induced growth, but that story rings true worldwide and we have seen a faster pace of growth than most industrialized nations nonetheless. And one could point out that the Fed is behind the inflation curve, which it surely is (and might be purposeful on its part, for now), but it has already boosted rates above the point at which many thought our debt-dependent economy would crumble.

However, the two items above are indeed surprises, ones that perhaps help explain the bipolar, range-bound stock market action of 2005: when economic data surprises to the upside, we see trading outcomes that seem to anticipate continued economic strength, when the numbers are weaker than expected, we see the opposite.

Even more specifically, the market seems to waffle back and forth on the question: will the Fed be able to keep tightening, or won't it?

When economic numbers are strong, we see generally stronger stocks, stronger commodities (presumably on the notion that manufacturing-led economies, particularly those of Asia, will keep consuming raw materials to supply our consumption habits), weakness in non-commodity foreign currencies (Euro, Pound, Yen) on the idea that the Fed will further strength the Dollar by continuing to tighten (I'm aware that one prominent foreign currency "analyst" - I put that word in quotes because I suspect he's a trader masquerading as analyst - has been writing, despite the overwhelming evidence in 2005, that interest rates don't matter in determining a currency's value against others. This is simply wrong, period. In fact, I'm truly astonished every time I see him write it; such comments suggest an astounding misunderstanding of the depth of today's currency markets, particularly the Euro, and the complexity of derivatives markets. The combination allows for cross-currency "carry trades," with the trade de jour being borrowing Euros short to lend US Dollars long, a situation that is inherently Dollar positive) and stronger markets stock markets worldwide. What's most interesting about this is that we have generally seen strength in the commodity currencies this year despite U.S. Dollar strength, which I can only conclude also stems from the notion that the U.S. consumer will continue to put upward price pressure on commodities via the world's manufacturing economies ( China, et al).

When economic numbers disappoint, on the other hand, we get weaker U.S. stocks, a weaker U.S. Dollar (based on the idea the Fed will not only stop tightening, but revert to cutting interest rates), a stronger Euro-Pound-Yen as non-commodity Greenback alternatives, softness in foreign stock markets and commodity price pauses. If sustained economic weakness does materialize, then a significant commodity correction should be the result (I am one who's quite bullish on the long-term commodity story, by the way); such an outcome would likely also be seen in those "commodity currencies." In summary, we sneeze and the world still catches the proverbial cold.

Am I crazy? Let's watch and see. With the U.S. Dollar again in overbought territory and facing technical resistance, gold solidly overbought on a short-term basis (it still trades more like a commodity than a currency), oil threatening to break down from a visible head-and-shoulders top pattern and the U.S. stock market in poor technical condition (in-depth Point and Figure analysis shows the picture to be more worrisome than some might realize… read any of Bruce Zaro's commentaries for expert commentary on the subject), market action is poised to follow-through on today's disappointing ISM services data in a downward direction. If these indicators are indeed poised to turn down in a stronger way than we've seen for awhile, perhaps our range-bound market is going to fret once again about recession (a reasonable concern many market watchers fear, yet over the last 18 months every bout of concern has been quickly replaced by a bout of optimism and vice-versa). Thus, the commodity currencies should also stand to correct as the markets worry about the much-anticipated end of the American consumer and the demand he places on the world's natural resources.

It seems to boil down to whether you think the U.S. economy can continue to grow or not; perhaps yet again we'll soon see offsetting data that suggests the economy isn't yet sunk that will once again raise investors' spirits and rally stocks back up within this trading range. However, if one thinks the economy will finally weaken, then in the name of simple prudent portfolio management a person should probably be looking to protect at least some profits in those commodity-related investments and commodity currencies.

In short: it just doesn't yet make sense to be a bear on the U.S. economy and a bull on commodities.

Chip Hanlon
President
Delta Global Advisors
800-485-1220
info@deltaga.com
www.deltaga.com

Currently the President of Delta Global Advisors and the founder of Green Faucet, Chip Hanlon is regularly featured in the national media for his global economic viewpoints and is a contributing writer for Real Money, the subscription service from TheStreet.com. Previously, Hanlon has served as the C.O.O. at Euro Pacific Capital, as the President of Unfunds, Inc., and as Vice President of Investments and Syndicate Manager with Sutro & Co.

Copyright © 2005-2009 Chip Hanlon

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