We see the two most important market developments in the new year as the United States being well on the road to energy independence, and a bear market for the yen. Both will have long range implications for commodity and financial markets.
The U.S. Energy Industry
The amount and quality of crude oil being drilled in North Dakota and Montana is nothing short of amazing when compared to mainstream estimates just two years ago. The current boom will have long-term implications for both commodity prices and the national economy. The first thing that comes to mind is we are back to two-way commodity markets for the first time in years. Before tapping the Bakken Oil Formation in North Dakota and Montana, and the leap forward in drilling technology this brought, traders had good reason to consider playing commodities from the buy side only. For years, the bull market in crude oil fed into other commodities, and the boom/bust cycle became a boom/correction cycle. The commodity sector -- from food, to energy, to precious metals -- was seen, because of population growth and improved health conditions, as a perpetual bull market. That has changed. Gasoline prices at the pump in the U.S. Midwest have dropped 25% in less than a year, showing everyone that ever-higher commodity prices is not a chronic condition. In fact, Energy Department officials in Washington are now concerned of the effects of long-term lower prices, which could hurt the reborn U.S. energy industry. What this likely means for the energy markets, and the other commodities markets, is they may no longer move like the asset class markets they were so highly correlated to over the last three years. Perhaps this is also why gold and silver, commodities that have acted like carry currencies in recent years, has been lagging these past months? Commodities have always had an Achilles heel. It's called supply. And not many people predicted the supply could come online like it did for crude oil.
Another big plus brought about by the increase in North American energy production is it tempers the negative effect on global energy and financial markets from potential conflict in the Middle East. The U.S. and Canada will always be seen as more stable trading partners than the Gulf States -- if you have a choice, you will always fill up the family car at a gas station in a nicer neighborhood. Any way you look at it, a return to two-way trade for commodities is the likely environment going forward. Lower commodity prices are also a plus for the global economy -- and central bankers know this.
There are always two sides to every market. And the biggest threat to lower commodity prices is climate. Another low precipitation winter and spring followed by a summer like the last two for the U.S. grain belt could push corn to $10 per bushel. Rain water is also integral to continuing to drill in the Bakken. To bring one barrel of crude oil to the surface means flushing four barrels of fresh water -- unrecoverable -- down the well. Locals call the convoys trucking in that water the "mechanical river." It is estimated that the oil and gas industry in the Bakken region will require as much as 5.5 billion gallons of water per year going forward. That is a lot of water needed at a time when underground aquifers are stressed from persistent drought conditions. The region currently has the water needed, but everybody relying on the new energy industry, and the old agriculture industry, needs to keep their fingers crossed that precipitation, or more specifically nature, reverses her current hot, dry trend. "Grain needs rain" as the old saying goes, and so does the U.S. energy industry.
We see the vote of confidence that Japanese investors have given their stock market in 2012 as confirmation that the Japanese yen has finally reversed its five-year bull run. Further confirmation is the absence of a bid in yen on global stock market corrections -- the yen is no longer a flight to quality currency, which is also a big plus for the global economy. It means the powerful Japanese investment class is finally deploying money towards overseas investments instead of bringing it home.
A bear market in yen would actually be a straightforward development for traders to take advantage of. Just sell rallies in yen futures or FXY, or buy dips in USDJPY. Supporting a weak yen is the likelihood that the Japanese will continue to embrace the QE policies that Washington used so effectively over the last four years. The problem for most traders and investors here is remaining patient yet vigilant to sell a yen rally, and on which time frame chart should they look for it? Short-term traders dominate today's markets -- over 90% of financial futures volume is day-traders -- meaning price corrections do not last long. You need to be quick to buy dips or sell rallies. One simple and effective technique is watch for entry points following 50% price retracements on the 4-hour or daily charts.
A related development to a bear market in the yen is strength in the yen pairs, i.e., AUDJPY, GBPJPY and possibly even EURJPY. Traders do not want to confuse a weak yen with a strong dollar. The U.S. Fed and Treasury will continue their no interest rate/weak dollar policy throughout 2013, meaning status quo for asset class bull markets such as U.S. blue chip stocks and carry pairs like AUDUSD and AUDJPY. 2013 will be a year of weak yen and a weak greenback.
The threat to a weak yen and strong asset class markets would be something we have yet to experience -- a Chinese slowdown -- the odds of which continue to lengthen, simply because the Chinese economy did better than many analysts expected in 2012. China would also benefit from the lower commodity prices that are likely on the table because of increased oil production in North America.
If you are wondering why we have not mentioned anything about a U.S. budget "deal," aka the Fiscal Cliff or debt ceiling, it's because we take the same position that the U.S. stock market is taking. U.S. stocks are telling us that a "good enough" deal will get done, which is good enough for us. To quote Winston Churchill: "We can always count on Americans to do the right thing, after they have exhausted all the other possibilities."