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.