On August 17 I wrote about commodity prices and their relationship with the dollar due to the fact commodities are priced in dollars. I want to revisit this topic with some data that has occurred since mid-August that shows what happens when the dollar is devaluing as a result of the Federal Reserve printing so much money.
I will use three currencies to make these observations: the U.S. dollar, the euro and the Canadian dollar. The rationale is the U.S. dollar is the currency global commodities are priced in, so it is the base. The euro is the alternative to the U.S. $ in the minds of many people, and there has been a move to price some commodities in euros by various countries. Some Middle East oil producers have occasionally priced oil in euros. I have also used the Canadian dollar because, as the largest supplier of oil and natural gas to the U.S., it is a significant commodity producer. Moves of the Canadian dollar are normally more muted than the moves between the US$ and the euro as the Canadian economy transacts 80 percent of all its non-Canadian business with the U.S. This means that where the U.S. economy goes, so goes the Canadian economy to a large extent, unless commodity prices in US$ terms rise significantly benefiting the Canadians.
The two commodities I used for comparisons are oil — a necessary consumable commodity — and gold, which has a totally different profile. Gold is at times a hedge against inflation, a hedge against the end of the world and an alternative investment, due to the fact investors have too much of everything else. This is otherwise known as diversification. The Indian Central Bank bought 300 tons of gold to add to its currency reserves earlier this year for just such a reason, and rumors are that both China and India are continually entering the market. This then makes gold the de facto, other currency.
Gold is the safe haven, currency "wannabe," even though it does also get pushed and pulled by consumer supply and demand, especially from India and China. During their festival seasons starting late August and ending in the Chinese New Year, they use the new larger amounts of disposable income to buy gold gifts. Is it coincidence that as we entered the start of this consumer buying period the price of gold has made record highs? Or is it a combination of consumer demand, Central Bank buying and fear/diversification buying? Does it matter? Not really, when you are looking at it from the perspective of gold and oil's U.S. dollar value vs. other currencies. We are not looking at the value of the commodities, but their comparative value vs. the dollar and then the euro and the Canadian dollar to see if the amount of money the U.S. economy is swimming around in is devaluing the dollar in both other currency and commodity terms. In other words, against everything that is not U.S. $.
When I pulled up the charts which show the comparative value of the euro, the US$ and the CAD against both oil and gold, I expected to see what the oil vs. currency chart showed, but I was not expecting to see what the gold chart showed and this I find alarming. Washington this is your writing on the wall – READ IT!
Gold vs. USD, EUR and CAD
Source: Bloomberg
Oil vs. USD, EUR and CAD
Source: Bloomberg
The two charts show the value of oil and gold in euro terms over the five-week period. Oil was two euros cheaper per barrel, falling from EUR 58.2 to 56.2, while in dollar terms it rose $1, from $74 to $75 per barrel. This, as I said above, was about what I expected to see. On the other hand, due to its hedge against everything status, gold rose in price in dollar terms from $1,227 to $1291 — $64 more expensive. In euro terms, it fell from EUR 969 to EUR 965.25 or EUR 3.75 cheaper.
If you compare the cumulative difference in value over the five-week period using today's spot of 1.333 it cost you $69 more to buy an ounce of gold than it did in Europe. Now you can see why I was so alarmed at these numbers. It is no coincidence that this week both orange juice and corn made new recent history highs. The same thing will happen with other commodities going forward. As an aside comment, this is how hedge funds make some of their money arbitraging these time lags and catch-ups in the value of both commodities compared to each other and currencies.
The next question is: If commodity prices go up won't that be inflationary for the U.S.? Yes it will be and that is the point. The Fed's strategy is no longer to keep price stability by fighting inflation, it is to maintain price stability by fighting deflation. It wants to cause inflation by making imports more expensive. To do this it has to devalue the dollar and that happens when you print too many dollars. When the inflation caused by higher import prices kicks in, it will be able to raise interest rates, unwind the accommodative rhetoric and tighten liquidity before the inflation gets out of control. As this happens, the dollar will strengthen and the commodity prices will decline in dollar terms, reversing what is described above and getting us back to normality while increasing the value of the dollar.
As the money supply returns to more normal levels — at least when compared to other currencies like the euro — we will have controlled and contrived a cyclical change. A very difficult thing to pull off and more than a great theory, if Ben is on the right track. The trick is not creating any bubbles in the process. The bubble most likely to be created would be a stock bubble due to the easy money —flash back to 2001! Hopefully the contraction in consumer fund availability as some of it is eaten up by the inflation will keep earnings down to a level where this does not happen.
This leads to the question of what the correct PE ratios are for a deleveraged corporate base. Where it used to be 20 times earnings, is it more like eight times earnings? If a higher number becomes more acceptable to the market as it tries to value at least six months ahead, we could start running into unsustainable levels that create a bubble.
The Fed has to put the brakes on and the only thing that is likely to do this, is a rapid rise in interest rates. Anyone who has studied technical analysis knows that the longer something stays in a range, the more violent the shift is when it breaks out of that range. When the Fed raises rates, the dollar will strengthen again. This I think is a likely scenario to cause the cyclical change, control the inflation/deflation and not let everything else get out of control. But what do you do about housing if it has not picked up by the time inflation kicks in? If the Fed raises interest rates too quickly, it will choke off any housing pick up and cause another housing dip.
Does anybody want Ben Bernanke's job?
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