Is the Buck Really Back?

by Jack Crooks

The big news this past week was definitely the dollar. The dollar rallied the most against the euro than it has in the past eight years. The dollar index climbed the highest it has been in six months.

So the question is: What's going on here? How can the dollar rally like this when the greenback's fundamentals leave so much to be desired?

Let me give you my theory about what's happening here. To really understand it, you need to start with a question:

What happened to decoupling, the idea that other economies are immune to the United States' weakness?

Well, it seems the sub-prime fiasco created bigger problems for the U.S. financial system than everyone thought. And now we're seeing this economic virus spread to other areas of the globe.

Need Evidence? It's All on the Nightly News

It's pretty easy to see other countries are feeling our same sub-prime pain. Just look at these recent news stories...

• German industrial orders dropped sharply - by 2.9% in June. That's disconcerting considering Germany's economy makes up one-third of total Eurozone output. And speaking of the rest of the Eurozone, many of those economies are bogged down by housing busts just like us.

• The International Monetary Fund [IMF] called out the U.K. economy. They predicted the U.K. would grow 1.8% and 1.7% for 2008 and 2009, respectively. All I have to say is: Kiss those numbers goodbye. The IMF's latest forecast calls for a seriously lower 1.4% in 2008 and 1.1% in 2009.

• Australia is battling sluggish household spending and their financial sector is being challenged. The National Bank of Australia recently reported a huge second quarter write-down, which they blamed on massive collateralized debt obligations (CDOs).

• And the New Zealand Treasury anticipates a second consecutive quarter of negative GDP growth. By definition, New Zealand will have entered recession once official numbers are released. They'd be the second OECD-member country since Denmark to sink to official recessionary status.

The reality is that the big three in the developed world - the U.S. the U.K., and the Eurozone - are staring into the face of recession.

How Does this Big 3 Recession Affect the Next "Superpower?"

As we were so often told when analysts were pushing the decoupling theory, China is set to take over the world.

But if weakness is spreading around the globe, what does that mean for China?

The 2008 Summer Olympics are just now beginning, and there's news that pollution has grown to far worse levels over the last few months. Chinese officials are putting all kinds of limits on how many cars can be on the road on any given day.

Additionally, in an effort to minimize excessive air pollution, Beijing is closing 105 factories. And should conditions worsen, neighboring cities could close as many as 117 factories combined.

Anticipation of the games gave Chinese companies reason to ramp up production. But what's concerning is these companies front-loaded production and an inventory glut is building up.

It makes you wonder how much extra production was jammed into the last quarter in order to prepare for air cleansing before the great games began.

I suspect plenty.

That's never good because they will have to sacrifice growth for as long as it takes to work through the oversupply.

The Commodity and Currency Circle

If the global economy is slowing, and China is forced to work through excess inventory, demand for commodities will be impacted. I'm guessing crude oil prices, in particular, will suffer from the realities I just described.

And remember, commodity prices and currencies influence each other in a self-feeding circle.

For example, falling crude prices could be the one thing that allows U.K. and European central banks to begin lowering their interest rates.

If and when that happens, the dollar will become more attractive relative to those currencies.

It wouldn't take a bold move on the part of the U.S. Federal Reserve, either (nor do I expect one).

A narrowing interest rate disadvantage between the dollar and euro - or the dollar and the pound - would be hugely supportive for the greenback.

In fact, this may very well be why the dollar HAS ALREADY been holding up given such incredibly dismal news day after day from the U.S. economy.

Take a look at this chart ...

Are Oil and the Dollar Finally Breaking Their Inverse Relationship?

Over the last year or so almost everyone's been pointing to the inverse relationship between the U.S. dollar and crude oil.

At the very left of the red rectangle on my chart, you can see where the tight inverse correlation began to break down. That's when the dollar bounced higher from its all-time low. Crude soared well beyond its record high at the same time.

Crude rallying and the dollar drifting slowly higher simultaneously? That was certainly no inverse correlation.

But from the furthest right point of that red box is where the tight inverse correlation has resumed. Only this time, the direction is in favor of the dollar. And it comes exactly after a new all-time high for crude prices.

Translation: The buck could be back.

The dollar has been able to continue its rally this week, even amidst a blitzkrieg of central bank announcements. While it has a long way to go - and recovery may not be swift - I think it's time to keep the dollar rally scenarios in clear sight. Especially now that other economies are catching the bug.

Comments

[MarkMedayski:]

All you said here is right,USD will rebound but first we will see it at 1.70 to the EUR by October and after we will see.Again you are right about the long wave cycles in currencies and commodities,but you forgot to mention that every cycle or " bubble" depending how one likes to call it,have corrections on it's way.
How come all USD bears become a bulls in the past week,it shows again that the crowd knows a shit about the cycles,each cycle will stop at some point,very extreme point.Crude Oil is in a bull market correction and now it is sitting for free 113$ per barrel,nobody buys.EUR at 1.4850 nobody buys etc.,etc.,
To make it short I must say,let's wait for craziness in this markets,at something all will say:WOW,Dow Jones at 5000 unbelievable,WOW!,Cude Oil at 233$ per barrell,WOW!,Gold at 1600$ an ounce WOW!,unbelievable.
Let us all get crazy,greedy,weird,sat... about everything,let the pressure of the cycle go it's own way and us carefuly manage risk and ride this waves till it explode so we can then easy surf the next,opposite wave.
Don't believe anybody,trust your killer instict only.Good trading day everybody,let the show begin today.HaHa.

2008 Aug 12 07:03 AM

[User 231885:]

Pretty good, Mark.

2008 Aug 12 08:20 AM

[williemo:]

Remember Warren Buffett's contrarian philosophy during the late 90's tech boom? Was he right? It depends on your time horizon. He was wrong, for the short term trader but right for the longer term investor. The same seems true now. As many have said, including our favorite friend on CNBC daily TV, 'you may be right', but being right won't win against 'the momentum of the crowd'. I've become a greater believer in this. However, if you are a 'balanced' investor, ie, one who has both short term and long term in mind, taking some positions in falling sectors as the near support can prove misguided in the short run, but brilliant in the longer term. I remember back in the late 90's, how many were saying how Buffett was 'old school' and couldn't keep up with the times. His patience was brilliant. I like this article, and it gives us a couple of ways to play the market, both now and in waiting for the next shift in sentiment.

2008 Aug 12 11:01 AM

[NOWHEREMAN:]

Germany and Japan both rely heavilly on the Asian economies to import their goods, for them if China sneezes they catch a cold. The US relies primarily on the developed world since we are a sevices rather than manufacturing oriented economy. With the combo of financial instability(put mildly) and deflationary pressures internally(wealth destruction) there is NO hope for a short lived Bear Market.

When China reboots after the Olympics, Germany and Japan will also. We will not. Our struggle is Financially based which has and will continue to bring down our economic growth on an ever expanding basis. Inflation is the least of our worries.

Did you hear the latest, the prices of 1/3rd of US homes are less than the price of the mortgages on them. Think the Fed will raise prices anytime soon?

2008 Aug 12 12:00 PM

[Urbane Gori...:]

Re: paultaut's comments: Europe has been and will continue to struggle with the same housing issues as we do. I have been reading 'International Living' for a couple of years now. Spain began to suffer about a 1 1/2 years ago. I also follow Great Britain. They began to struggle about 7 or 8 months ago. Germany's issues of stagnant growth are well known as are the issues with Banks throughout Europe. (Most recently Ireland and England..)

Where there is still growth in home values seems to be South America. (Panama and Brazil in particular).

It would seem to be still true that our problems affect the remainder of the world. If our issues continue to depress the rest of the world's economy, then I'd watch South American home values as a 'canary' and expect that commodity driven continent to follow suit.

jegan ;-)

2008 Aug 12 04:36 PM