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To paraphrase Soros, money is made by discounting the obvious and betting on the unexpected. With that in mind, what is considered today to be the obvious?

  • Inflation hitting double digit numbers due to Fed’s expansionary monetary policy.
  • Gold going to $2000, $4000 (Paulson), $10000, or $15000, depending on the pundit.
  • The USD continuing its downward trajectory indefinitely.
  • China consuming the world's resources en masse.

As to the unexpected:

  • Lower commodity prices.
  • A strengthening US recovery.
  • Low inflation.

The question then becomes: How can investors profit from the unexpected coming to fruition? One of the answers incudes a long position on the USD (US dollar) with a short on the CAD (Canadian dollar) via the forex market.

click to enlarge images

USD/CAD Chart

In the last 6 months, the USD/CAD has made a huge move from a high of $1.02855 to a low May 2nd of 0.94446. The main driver behind this move is commodity prices, as a staggering 50% of Canada’s economy is based upon oil, with a significant percentage of the remaining 50% also around commodities. This can be proven via a correlation study (lower red line), which shows the USD/CAD and light sweet crude oil futures with a correlation of -0.81537.

Oil USD/CAD Correlation Study

As you can see, the correlation broke down in February of this year with the commencement of the Arab Revolution that swept across the Middle East. In that circumstance, oil futures acted as a lead indicator for the USD/CAD, as the currencies quickly caught up to the spike to retain its -0.8 correlation. Zooming out further, the yearly correlation is even stronger, with a reading of -0.94 from 2003 until today on a weekly chart. There are diversions around major macroeconomic events, but each time it reverts back to the mean.

2003-11 USD CAD Correlation

When dealing with the relationships of currencies between countries, there are a multitude of other factors to consider, but what makes the USD/CAD economic relationship interesting is that Canada does 80% of its trade with the US, thus is hugely dependant on their economy. This reliance negates many other factors that would pose as larger influences on two countries’ currencies whose futures weren’t mutually dependant.

Therefore, it’s safe to say any bearish position on the USD/CAD is logically accompanied by a bearish position on commodities, and vice versa.

This past week we witnessed the initiation of the run on commodities led by silver, which after a spectacular rise of over 900% came crashing down, followed by oil and gold to a lesser extent. As usual, many are touting this as a “buying opportunity”, which reminds me of the "buying opportunity" with financial stocks back in 2007. This video never gets old; start at 2:37 to see the round table on the housing buying opportunity followed by the financial stocks buying opportunity.

Back to the commodity correction, it’s amazing that this is such a contrarian position, especially given the vogue of calling "bubbles" and recent run up in commodities as demonstrated by the ETF DBC:

DBC Chart

Granted, this is far from the exponential rise that we’ve grown accustom to seeing, but it represents a 43% increase over the past year, 60% before the recent drop.

The rush to commodities has in part been a reaction to the apparent wide spread printing of money, by all the world governments, but the US government in particular. Interestingly enough, M2 is in line with historical amounts after the initial increase to cushion the deleveraging cycle.

M2 Money Supply

What is up dramatically is the Fed’s purchase of Treasury bonds as a means of keeping short term interest rates low and providing liquidity to the system.

QE2

This is very similar, many say exactly the same, to printing money, but is coming to an end in June. Once that process completes, unless M2 picks up the slack you have a potential catalyst for continued weakness in commodities, especially speculative items such as gold and silver. There is risk that the Fed will enact another round, but with their new public friendly policy which now includes press conferences, it would be reasonable to assume an announcement we have yet to hear.

Further ensuring no QE3 is the latest US job numbers. I resist the temptation to get excited/upset regarding every report that comes out slightly above or slightly below expectations, but it is noteworthy that a strong downtrend has clearly begun. The rise in unemployment to 9% is due to more entrants into the job market; this is also a positive sign as the pursuit of employment usually begins with the belief that employment is obtainable. In addition, the latest numbers represent the largest amount of private sector hiring since 2008, and despite what Obama’s economic advisors might think, it is the private sector that drives the economy.

Employment Chart

Hiring by businesses is a signal that we are close to the beginning of what is known as the virtuous cycle. This is the idea that once employment begins to pick up, individuals earn income, which they save/spend, which creates more jobs, which earns more individuals more income, which they save/spend, ad infinitum.

This naturally re-raises the issues of inflation, but the type of inflation you encounter due to earnings and spending growth is much different than the inflation from expanding the money supply. The latter is known as stagflation, where wages stay stagnant but the cost of living rises, whereas if you slowly raise interest rates to maintain sustainable economic growth driven by growth in wages, you are dealing with a beast of a different name.

The wage related interest rate rising is fantastic for the USD/CAD trade, as when the US begins its rate rises to long term levels (6% to 8%), you’ll see significant appreciation of the US dollar. Thus, if this narrative plays out and the trend of the US economy continues, the USD/CAD position will be one of profit.

Focusing on oil prices, I said in my March 7th article entitled “Will the Arab Revolution Result in Higher Oil Prices” that the recent spike was unsustainable and not based upon fundamentals. The countries that are in revolt, Libya and now Syria, are not the major oil producers. If there is a large unrest in Saudi Arabia the fundamental story is there, but that has yet to materialize and doubtfully will based on Saudi Arabia’s demographic structure and recent payout to opposition groups.

Does that mean oil is going back to $60 a barrel? Possibly.

When speaking of commodities, it’d be foolish to forget China. They are consuming commodities at a record pace as the 2 billion plus people who lived under the tyranny of communism finally are beginning to enjoy the living standards and freedom that accompany capitalism. That being said, even with the spectacular rise in living standards of the past 200 years, commodities have done extremely poorly when adjusted for inflation.

Commodity Chart

How is this possible? It reminds me of a bet I learned of at UBC from my economics professor Mauricio Drelichman, whose courses I highly recommend. It is commonly known as the Ehrlich – Simon wager. Ehrlich was the author of The Population Bomb, a book predicting widespread famines by 1975 because of resource constraints. Simon, an economist who argued that resource constraints would never bind, challenged Ehrlich to a bet in which Ehrlich chose 5 resources in 1980 and if by 1990 the same quantity of resources sold for more than $1000 adjusted for inflation, Simon would pay Ehrlich the difference. Conversely, if they sold for less, Ehrlich would pay Simon.

The results?

During the 10 years, inflation adjusted prices of all minerals dropped more than 57%, Simon would have won even without adjusting for inflation.

The lesson learned is that raising living standards around the world don’t necessarily mean higher commodity prices. In China’s case, it only accounts for 6% of world oil imports and and 8% of consumption, and in agriculture China actually runs a surplus in trade, producing more food than it eats. For a more detailed look into China’s effect, or more appropriately its over hyped effect, I recommend reading this paper.

To quote my old professor, ignoring history will cost you.

On top of all of this Mark Carney, the head of the Bank of Canada, has recently acknowledged the negative effects of the higher loony on Canadian businesses. My earlier point is confirmed in regards to the reliance of the two economies, but it also signifies that the Bank of Canada may take action to reverse the trend, putting future rate hikes on ice. Specifically, Carney stated that the Canadian dollar’s strength posed:

A downside risk to growth and inflation in Canada.

and

Growth has been slowed quite markedly in the second quarter. We think the underlying track is around 2 to 2.5% (growth) through the balance of the year, but there could be a lot of noise around that because we’re going to have to face the auto plant shutdowns (that) we’re having already.

In addition, Canadian consumer debt levels are at record highs, similar to where they were in the US before the crisis.

US and Canadian Household Debt

Clearly there is plenty of challenges facing the Canadian economy, making the USD/CAD trade one with little downside risk and plenty of upside.

To put this trade on, I recommend a limit order at 0.9649. This is a tight order, and a better entry could potentially be obtained, but that could also result in missing the trade entirely. It has strong resistance at 0.97; once it breaks that level I see it continuing on its way back to $1.05 to $1.10 over the next 2 years.

USD CAD Zoomed

Expect the unexpected.

Disclosure: I am long the USD/CAD. Position was initiated April 18th, tripled May 5th.

Source: The Commodity Run Is Over: Time to Go Long USD/CAD