The Dollar/Oil Surprise: What Does 2009 Hold?

Think back to the beginning of 2008. If you’re like most investors, you were probably wondering just how low the dollar might fall in 2008, and how much higher oil would surge. But, Mr. Market surprised us in a big way in 2008.

Now the question seems: How much higher will the dollar go, and will oil continue to plunge lower?

Many were so surprised by awesome and swift change of fortunes in 2008. So let’s take a look at some of the reasons for the swift reversal of fortunes for these two major asset classes. There are solid fundamental reasons why the oil-dollar relationship has been so tight, and will likely continue in 2009.

The Secret to Currencies: It’s About Money Flow

I’ve had an opportunity to talk with a lot people about currencies this year. And the most asked question by far is this: How can the dollar rally when the U.S. economy is doing do poorly, to say the least? It’s a good question. Let me explain.

One of the things you must always keep in mind when dealing with currencies is this: The price of a currency is determined by the currency’s supply and the demand for that currency. It is that simple!

Though it can get complicated when we go through all types of analytical gyrations in order to figure out exactly where supply and demand sit. Now, think about the credit crunch. It was a sea change event in the global economy that completely altered the supply and demand dynamics for every single asset class — stocks, bonds, commodities, and currencies.

Let’s look at how these key asset classes acted together during the last market cycle, i.e. before the credit crunch changed everything. If you examine the chart below I think you will see that one key asset class — the dollar — didn’t play well with others. It went down as the other asset classes went up.

The chart below is a bit convoluted, I know. But, it is important to understand because it helps explain how money flow is critical to forecasting the dollar’s path. As you can see below, the dollar index tended to travel in the opposite direction of gold, oil and stocks before the credit crunch hit the global markets in 2007.

Before the World Had Heard of a “Credit Crunch”

2001 - 2007: Gold, Stocks and Oil Hit Multi-Year Bull Market. Notice that each of the asset classes, except the dollar, launched into a multi-year bull market back in January 2001! Back then, Fed, European Central Bank (ECB), and Bank of Japan (BOJ) all juiced the markets with liquidity. At the same time, investment banks added even more liquidity by creating literally trillions of dollars in new derivatives.

Think of this era as a dollar-based liquidity explosion for all asset markets except for the major funding source for all this growth: the U.S. dollar.

Fast Forward to 2008: Now, let’s take a look at this same chart after the credit crunch hit the global markets in 2008. The dollar (red line) bottomed the week of March 10th, then gold (brown line) topped at the same time. By then, stocks (blue line) had already topped. A few months later, oil (black line) also topped in July.

Gold, Stocks and Oil Topped Out While the Dollar Surged

What happened? Why the big change? Money flow! Money poured back into the U.S. as the impact of the credit crunch forced major institutions to deleverage their positions.

The big players were (and still are) fighting for their lives. They had to sell risky asset investments overseas and bring money home. And we’ve also witnessed big repatriation of retail mutual funds back into the United States. In four months thru October 2008, U.S. residents sold a net US$126 billion of foreign securities.

So, this is why it didn’t matter that the U.S. economy was in the tank and getting worse. Money flowed back into the dollar because of the credit crunch! Remember, it is supply and demand.

We had, and continue to have, a situation where the supply of dollars (in the form of trillions in dollar-based derivatives) is evaporating. In other words, we’re seeing a lower dollar supply worldwide. At the same time, we’re seeing a massive decline in global demand as all the major economies are entering what could be a very deep recession!

Where Are We Headed in 2009? Another Big Surprise in the Making!

Unfortunately for most people, I expect global economic conditions to get a lot worse in 2009 before they start getting better. Why do I say this? Because global trade and demand has vanished at an astonishing rate and seems to be accelerating downward.

Consider these facts:

1. In November, Japan recorded the biggest single decline in exports ever; back into a nasty recession and deflation they go!

2. China exports declined in November for the first time in seven years; unemployment is soaring as factories close everywhere in the country; the export model is in jeopardy; social stability is paramount in China at the moment.

3. Global marine shipping rates have fallen up to 95% and more.

4. Plunging energy prices have eviscerated the Russian economy so the government is now draining reserves; major social unrest is in the cards.

5. Spain is in panic mode — ditto for Ireland, Italy, Greece, Portugal, and other members of the European Union.

6. Germany (the engine of euro growth and model of fiscal discipline) is heading into deep recession — latest consensus forecast is 2.7% decline in their economy.

7. The U.K. economy is staring into the abyss; and it looks to get worse.

8. Credit for emerging market nations has virtually disappeared. Export demand for their goods has vanished. They are relying on emergency International Monetary Fund (IMF) loans as a stop-gap measure, but the IMF tap has its limits.

9. The U.S. consumer has finally stopped shopping and is saving. That’s a good thing long-term for capital creation, but it’s a disaster in the short-term because the U.S. consumer is the catalyst for global demand and rising unemployment means no rebound by Mr. Consumer anytime soon.

Governments are pumping up money supply, cutting interest rates, and spending taxpayer money as fast as they can, but it doesn’t seem to be helping much.

This tells me that the major market deleveraging will have to run its course before economies begin to respond. And in a deleveraging phase, as I showed you above, the dollar (the world reserve currency) tends to do well…or at least be supported.

But there is another major surprise on the horizon that I believe will lead the dollar to its next big rally phase — concern that the European Monetary System, which represents the euro currency, will come apart!

The euro is the key currency competitor against the dollar. When the euro does well, the dollar does badly, and vice versa. But as global demand continues to shrink, I expect key member countries — either Italy, Greece, Ireland, Portugal, or Spain — to completely abandon all fiscal responsibilities they must maintain as members of the European Monetary System. And that will hurt the euro.

It makes sense, and here’s why.

Euro member countries have no sovereignty on monetary policy. That is set in Brussels by the European Central Bank (ECB). And the ECB is woefully behind the interest rate curve. And the big member country — Germany — is railing against providing a major stimulus to support the rest of the union members. Why should Germany pay for other countries' lack of discipline?

This is the Achilles' heel of the European Monetary Union — Since member countries have no fiscal responsibility, they can spend all they want and the ECB has no say or power to stop them. They can also spend, as little as they want if it suits their citizens’ needs. In other words, there is a lack of political sovereignty behind the key member states that form the Eurozone, and back up the euro.

In an environment where most countries — and their politicians — are scrambling desperately to provide stimulus to their citizens, I expect several member countries in Europe to abandon their Brussels-based fiscal shackles and break the bank.

If that proves true, it will rattle the foundation of trust and cooperation the euro was supposedly built upon. Trust and cooperation work fine when everyone is making money and growing.

But in the dark days of a downward business cycle, with the wolf at the door, it’s everyone for himself. This is the first major test of the euro as a currency during a major down cycle.

Don’t be surprised if it fails. And if it does, it would be very bad news for the euro and would usher in a whole new wave of money flowing to the U.S. dollar — a wave more-than-likely to trigger a powerful leg up in the greenback.

The Next Direction for the Dollar…

It should be an interesting year. But once again, I’m betting the dollar will rally. Be prepared.

Comments

[Jack K:]

Very interesting concepts. It does make sense that the Euro would have trouble as economic times toughen. Europe fought amongst itself for 2000 years. I am sure that I was not the only one who said when the Euro was first started that it can not last. Too many selfish interests.

2008 Dec 30 07:00 AM

[Ishortyou:]

Europe is a bunch of nations finding their way and own identity, Napoleon, Hitler tried to unified Europe under one identity, one flag, one language, one race, one culture, but they failed due to stupid, senseless blunders, now Europe is broken in small little countries that by themselves are not match to the superpowers like Russia and USA. Now they realize that to put a balance to that the European Community is a tool to do that, so far seems to work but god knows for how long, that until little warlords appear in the scenario to secure their own interests.

2008 Dec 30 07:46 AM

[Peter Cooper:]

Would that then be bad for gold? It has not tanked in the same way as stocks and oil, indeed gold is up on the year and considerably so in non-dollar currencies. One safe hedge is to keep money in both dollars and gold - but I agree that the fundamental dilemma for dollar devaluation is devaluation against what? You have not even used the argument that other countries are behind on the recovery curve, and that what went down first will be first to recover. On the other hand, the US economy looks so fundamentally flawed that I will keep gold anyway!

2008 Dec 30 08:07 AM

[CaptainJJack:]

I agree with the thoughts on the Euro. The European Central Bank appears to be trying to engineer deflation in Europe, and I expect unemployment to soar.

On the other hand, I have a very difficult time with technical charting. It has always seemed to me that the inevitable result is to lead you to buy high and sell low.

They are always looking for "breakouts" as buy (on the way up) and sell (on the way down) signals. You have to wait until the market bottom "holds" (whatever that means) before you buy (presumably, you wait for the "breakout"), but if there is a "bottom breakthrough", then that is a sell signal, meaning that after riding the tide all the way down to some arbitrary level, you are now supposed to sell because you broke through that arbitrary level.

Like I said: Buy high and sell low.

2008 Dec 30 08:33 AM

[patio:]

I wouldn't buy gold now, but like you if you already have it, I'd be hard pressed to sell. so many unknowns, so many possible outcomes.
However, I hold the same position as the author, and have remained 100% in cash ( AAA CD's ) for over 15 months. While I read all the inflationista's pieces, I remain unconvinced, for the forseeable future. Demand destruction, along with once in a century pyschological shift to saving, will keep prices down for a good long time. I hope this community can read the tea leaves and see the eventual shift to inflation when it exposes itself, and yes, I also realize it may be very sudden when it occurs.
"May you live in interesting times". Darn Chinese!


On Dec 30 08:07 AM arabianmoney.net wrote:

> Would that then be bad for gold? It has not tanked in the same way
> as stocks and oil, indeed gold is up on the year and considerably
> so in non-dollar currencies. One safe hedge is to keep money in both
> dollars and gold - but I agree that the fundamental dilemma for dollar
> devaluation is devaluation against what? You have not even used the
> argument that other countries are behind on the recovery curve, and
> that what went down first will be first to recover. On the other
> hand, the US economy looks so fundamentally flawed that I will keep
> gold anyway!

2008 Dec 30 08:41 AM

[DiggerUK:]

I am getting more convinced by the day that no central banks can hold out against ZIRP.
I imagine the first question that Obama is going to ask in a few short weeks isn't going to be "Wheres the carriers, wheres the subs" It's going to be "Wheres the dollar"
As the world's major reserve currency it is ideally placed as a fifth column in damn near every corner of the global economy.
The dollar has no seat on other central banks rate setting committees, I just think it's making them an offer they could refuse.

2008 Dec 30 08:42 AM

[long_on_oil:]

The government is buying up the bad debt, bank borrowing interest rates are at record low levels, cd rates are close to record low levels and credit card rates are sky rocketing and the banks can not make money.
I can't figure this mess out so I will not buy financials period.

2008 Dec 30 08:54 AM

[Prudent Man...:]

Those charts look like Madoff's vital signs.

Your guess on oil can't be any worse than the invisible government at Goldman.

2008 Dec 30 09:14 AM

[scotty1560:]

Excellent analysis- makes sense.
I lean towards the dollar getting stronger as well and negatively impacting
my gold and oil stocks for a year or two. The entire global economy needs major retooling and re balancing at this point, going to take some time. Oil has other
factors like geopolitics and bad weather like hurricanes, so it's a bit of a wild card.
Hard to see gold rally without the dollar weakening and oil trending up, deflation
will stick around for a bit, though I feel stagflation is the outcome.

2008 Dec 30 10:20 AM

[Rob Viglione:]

Foreign currency weakness is certainly a reasonable possibility for USD gains, but I see nothing fundamentally good about our currency. The central bank is intentionally trying to devalue it as quickly as possible, and the incoming administration seems set on spending trillions of dollars in deficit.

There is a chance the EU will experience turmoil, but the likelihood that it causes implosion of the EUR is not high. In absence of this EUR crash I cannot see much reason for the USD to appreciate.

2008 Dec 30 11:39 AM

[L Boyd:]

Article has a lot of common sense and I very much agree.

@Patio, I'm on the same page friend. Inflation will not hit us anytime soon, but when it does it will skyrocket. We've still got a TON of de-leveraging to do so I don't think that we're in any near term inflationary pressure. That being said, there are so many USDs being pumped into the market, that when this turns around, the USD will go into a downward spiral. Not a bad time to go short the dollar in the next couple of months, I would wager; no question that if the Euro fails, the dollar would skyrocket, but again, I believe that'll be a relatively short-term spike. In the long-run, the yuan will be a very attractive alternative to the USD. Once again, if you can keep a long-term investment view while taking advantage of near-term opportunities, you stand to do very well. I feel that EVERYBODY knows what's going to happen; the trick is timing all of it right.

2008 Dec 30 11:40 AM

[johnbee:]

why should the Yuan be a good investment? It has the same problems as everyone else doesn't it?

2008 Dec 30 12:22 PM

[JCC:]

Very good analysis! Recent articles by Nouriel Roubini and Robert Shiller add credence to your analysis. Some think that the dollar will continue to appreciate as a safe haven currency through the 1st half of 2009.

The possibilities states dropping the Euro and returning to national currencies is amazing, yet there is a lot of news to support the possibility. I wonder what will happen with Yuan?

2008 Dec 30 12:41 PM

[scotty1560:]

I listen to both camps on the dollar and it's a tough call, effecting
every decision regarding assets from equities, metals, real estate, oil.

Lately, I seem to think dollar cycles higher, adding to deflation pressures.
As L-Boyd posted "for how long".

Smart guys like Marc Faber in one camp and Jack Crooks in another..
tough call.

Opinions welcome.

2008 Dec 30 12:48 PM

[silverwood:]

I agree with many of the point the author has made except this one;

"Don’t be surprised if it fails. And if it does, it would be very bad news for the euro and would usher in a whole new wave of money flowing to the U.S. dollar — a wave more-than-likely to trigger a powerful leg up in the greenback."

The US economy will be in shambles, and bankrupt also, so the money will flow to where the growth can occur and that will be Asia as their population strive for middle class lifestyles.

And the wave count on the chart is skewed, we will see a USDX at 52.

2008 Dec 30 08:48 PM

[secmaven:]

Main Street in Europe is buying gold, not dollars. I go with the wisdom of European investors who have been there and done that before. The gold buyers came out the other side as winners. "Investing" in the fiat currency of a former and failing superpower is not a viable long term strategy.

2008 Dec 30 10:32 PM

[auto44:]

Good Job. Most central banks including ours have the presses running. It seems to me that natrual resources-commodities will rise and currency no matter what brand will fall due to increased supply.


On Dec 30 11:39 AM Rob Viglione wrote:

> Foreign currency weakness is certainly a reasonable possibility for
> USD gains, but I see nothing fundamentally good about our currency.
> The central bank is intentionally trying to devalue it as quickly
> as possible, and the incoming administration seems set on spending
> trillions of dollars in deficit.
>
> There is a chance the EU will experience turmoil, but the likelihood
> that it causes implosion of the EUR is not high. In absence of this
> EUR crash I cannot see much reason for the USD to appreciate.

2008 Dec 31 12:10 AM

[auto44:]

Lest we forget a huge amount of deleveraging has already been done. There is at this time a massive wall of money waiting to be reinvested. When the fear is again replaced by greed all assets will out value paper.

2008 Dec 31 12:17 AM

[Moon Kil Woong:]

Although I am bearish gloom and doomsters are also likely to be disappointed. The US can only pump up the dollar so much with deficit spending etc. I doubt even the US Government will be stupid enough to push it too far ($1 trillion over a couple years). One trillion, as we all know is not enough to counter the de-leveraging so look for a bleak 2009 but not a dollar/ US government bond collapse anytime soon.

Sadly, even if we spend $1 trillion, ending the Iraq war will negate a lot of that stimulus considering not only was Bush Jr. dumping tons of on budgeted money into the war which stimulated inflation and the economy that would have dropped a lot longer ago, but also spent hundreds of billions of dollars in borrowings which now we all get to pay for the rest of our lives in taxes. The real cost of this war may make any Obama spending spree look like an austerity program.

We already have enough bad news on our plate without people asking for a visit by the grim reaper of stagflation.

2008 Dec 31 02:27 AM