U.S. Dollar Signaling a Changing Tide?

by: Michael Fitzsimmons

The Fed cut the fed funds rate to 2% and curiously said "It will be necessary to continue to monitor inflation developments carefully." Heh heh. One could argue if the Fed were really monitoring inflation, rates would not have been cut (yet again) in the first place. That said, of course the markets loved it and the U.S. dollar has actually strengthened this week. The talking heads in the media are now cautioning commodity inflation will fall as the U.S. dollar continues to strengthen in the weeks and months ahead. Is the tide changing or is this simply another financial head fake?

I've gotten a few emails recently about gold falling from $1000 to $850 and the drop in oil prices and asking if I was changing my investment advice. Was I still bullish on energy, precious metals and commodities? Short answer - you betcha.

First let me say that dollar hedges [MERKX, PSAFX], gold and precious metals (streetTracks Gold ETF (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), VGPMX), and commodity plays (DB Commodity ETF (NYSEARCA:DBC)) should not be more than 5-15% of a "normal" investor's portfolio. The exposure thus provided is an insurance policy against both a falling US dollar and rising inflation. These investments, in general, will decline when the U.S. dollar strengthens. However, don't be frightened into selling these investments because, overall, not much has changed.

I find it rather amusing the U.S. dollar strengthened this week as the Fed cut rates in the face of rising inflation. I believe, as does Axel Merk, that the Fed is intentionally supporting inflation as the lesser of evils in its fight against financial turbulence and a slowing economy. Structurally, however, not much as changed. Sure, exports have picked up, but still the U.S. government's huge fiscal deficit, combined with a trade deficit exacerbated by high oil prices, are facts that won't go away regardless of Fed action. U.S. tax and energy policies are so far off base that neither deficit will improve for a long, long time.

Big oil has reported and the earnings results were stellar even considering Exxon's "miss". Exxon increased its dividend but not enough to keep me off their backs. Overall, the theme of big oil's earnings reports was flat production, upstream strength, and downstream pressure. Record high oil prices continued to favor upstream operations and those companies with more oil production and less oil refining (Occidental Petroleum (NYSE:OXY) for instance). Crack margins essentially evaporated as high crude oil prices, slowing U.S. gasoline demand and the ill-advised ethanol policy have actually, despite McCain and Clinton's election year antics, kept gasoline prices lower than they otherwise would be. If driving season gasoline demand picks up, gasoline could easily hit $4 a gallon this summer.

As far as oil prices dropping, is a drop from $119 to $113 really that big a deal? I mean oil prices are still ONE HUNDRED AND THIRTEEN dollars a barrel. Could oil decline further, perhaps even under $100/barrel? Well, of course it could. Does that mean it's time to bail on energy investments? Of course not. Oil field depletion is still a ~5% fact in Alaska, Mexico, the North Sea, and some of Saudi Arabia's largest oil fields. Worldwide production has to find roughly 4 million barrels a day per year in NEW production just to keep up with depletion rates.

Then we have to take into account demand growth in China, India, Russia, and the Middle East. Iraq continues to be the biggest opportunity around, but as Chevron's (NYSE:CVX) CEO Dave O'Reilly recently pointed out, there remains two large hurdles for setting up operations in Iraq: 1) security and 2) ironclad contract agreements. Meanwhile, there is no comprehensive U.S. energy policy. Given these realities, and considering that the U.S. is the largest consumer and importer of oil, how can this possibly be bullish for the U.S. dollar or bearish for energy investments? Ain't happening.

As far as gold goes, we have certainly seen a pretty good hair-cut. Time to get out? Nope, time for folks who don't have a position in gold to obtain one. Kitco.com and APMEX.com are awaiting your orders. Gold moves very quickly in both directions. Though the uptrend was arguably broken, it wouldn't take much in the way of world events or inflation upticks to resume what I believe is a long term climb. Investors with positions in gold should hang in there and be patient.

With respect to commodities, I am a bit less confident simply because it's not my game, so-to-speak. I still maintain that the Bush administration's ethanol policy is one of their worst policies (and that is saying something) and should be stopped sooner rather than later. Food inflation should then slow as we stop using corn to power our SUVs. Yes, gasoline prices will go up, but they should go up. Perhaps that will prod Congress to adopt a real energy policy, but I won't hold my breath, and neither should you. That said, I do agree with Bush that the time has come to open up ANWR and the outer continental shelf to oil production. They can drill offshore in Norway, Denmark, and the UK, but not the U.S.? This doesn't make sense.

Considering the huge oil bind we are in, and the long lead times to get these resources on-line (7-10 years), the U.S. had better get on the stick with these projects now. By the way, the U.S. government, like governments all around the world, should get its fair share of the oil royalties. This money should be funneled directly into alternative energy based mass transit, tax incentives for solar and wind investments, nuclear energy development, and high mpg alternative auto transportation tax breaks.

Meantime, stick with your energy investments for the long run. They will power your investment returns and protect you from a falling U.S. dollar and rising inflation, both of which, in my humble opinion, will continue the trend of the past few years.

Disclosure: The author is long DBC and VGPMX.