Commodities Rising in the Wake of a Falling US Dollar

by: Sufiy

The US Dollar enjoyed happy times for most of the last century. In its full glory it was driven by a bull market in equities from 1980, economic expansion and, most importantly, by its safe haven appearance. After the collapse of the Soviet Union, nobody could challenge the USA as a super power and its "world’s policemen" status. Dollars were welcomed everywhere as the official tender for transactions, and entire nations kept their wealth in USD denominated assets. All black markets across the world and emerging economies had only one official currency – American Dollars.

Not any more. First, dollars fell out of favor in shady circles: try to buy any real estate in Eastern Europe now - dollars are not welcome. Now government institutions are ready to accept necessity of diversification out of reserve currency of choice. The Dollar as any other FIAT currency is not backed by any tangible assets apart from a “solid” government promise to pay back. This promise is based on the government's ability to create wealth and spend less than its revenue in the form of taxes, and its ability to manage cash flow - its trade and current account. The US Dollar's fate is based on trust. Trust that the government will repay the same value plus interest on its IOU, trust that government inflation figures are correct and your interest payment or yield on US Treasuries will be above real inflation and provide a positive return.

In August we witnessed that the trust is gone, first in subprime securities, then in rating agencies. All financial systems were put on hold because nobody trusts anybody. The academic approach that derivatives are helping spread and reduce the risk has proved to be wrong. The risk was spread to the least prepared, those who trusted the AAA ratings of subprime engineered junk. When even the risk-averse-sleeping-state-owned German banks get hurt in this turmoil, what is happening with risk proactive US banks?

Conservative Swiss UBS (NYSE:UBS) was quick to shut down hedge funds with mere losses of a few hundred million dollars and the CEO was fired within two weeks after that. In the USA, a high profile victim so far is the CEO of Standard and Poor’s rating agency, which was given high ratings to tranches of CDO being paid by issuers of these junk paper. There will be more victims to come and losses will be exposed, but the first victim is already apparent. The US Dollar is losing its trust and appeal as a reserve of the last resort. The dollar is no longer preserving value, nor is it providing security as the most common investment instrument of US treasuries.

Dan Norcini reported:

This is the fourth consecutive week in which Treasury holdings by foreign Central Banks in the US Fed Custodial Accounts have fallen. I am continuing to monitor this development as it seems to be something flying under the radar screen of most analysts in spite of the ramifications involved should it continue and become a serious trend.

You can see the consequences of Stagflation and it's victim – the US Dollar. After the subprime shock and the housing melt down, the US economy, in real inflation adjusted terms, will be in stagnation in the best case scenario. The government and Mr. Bernanke will try to fight this subprime fire by adding more gasoline. All these bubbles were created by easy credit and now they will try to save the financial system by pouring more money into it, creating monetary inflation and eroding the value of the USD and other FIAT currencies. The long term chart of 30-year US Treasury Yield is in its definite break out from multi year down trend after double bottom reversal formation. The appetite for subprime currency and assets denominated in it is falling and, in order to sell it even AAA rated, you need to raise the premium - yield. In addition, more selling of treasuries by China, Japan and other US creditors will put more pressure on prices and yield will go higher with USD going down.

Now this process will be accelerated with active role of Sovereign Wealth Funds [SWF]. In order to diversify their reserves from the US Dollar wealthiest countries have created SWFs. According to Financial Times, the top ten have a 2.4 trillion dollars cash pile, with the biggest one, Abu Dhabi Investment Authority [UAE], standing at 875 billion dollars. It is also important to note that China has so far allocated “only” 300 billion to its State Foreign Exchange Inv Corp Central Huijin. This comprises less then 25% of its more then 1.3 billion reserves. In the case of UAE, it is 90% of reserves. Now all these money will be deployed in order to protect their value and secure resources for growth in all these countries.

As the US Dollar continues, Gold and Silver will be going up driven by the economic fundamentals of supply and demand. All raw materials will appreciate in their value. Demand created by rising population and infrastructure development in BRIC countries will push commodities' prices higher. Also, these countries are not experiencing any lack of paper dollars losing their value by the hour, further leading them in their willingness to exchange dollars for the real goods. As more paper money begins chasing the same supply of real goods, it will lead to the higher prices.

PGM and base metals industry will be driven by further consolidation. The trick is that you can not create any new supply of commodities, gold or silver in a split second as you can create supply of new credit in the financial system. Mr. Bernanke does not even have to use helicopters for flush of liquidity rescuing markets, just political will and PC in the Federal Reserve System. The new commodity supply story is completely different – the cycle is long, boring and risky. You have to find deposit (it is rule of thumb that from 1000 drill holes only 10 will lead to economic discovery and only 4-5 will become mines). You have to secure all permits and financing. You have to build the mine with all of the necessary infrastructure: water, electricity, safety and environmental issues. You can allow from 6 to 10 years depending on the type of commodity, technical issues and permitting process. After 20 years in a bear market, the commodities industry is feeling the heat right now with the lack of qualified personnel, drills and diminishing resources base. Majors are not even exploring any more and are cultivating partnerships with Junior mining and exploration companies, spreading the risk and running short on time. Any economic deposit with a proven time schedule to become a mine is under constant search in the industry.

Once we identified our major trend, the demise of US Dollar and the end of its status as reserve currency of choice, we can formulate an investment approach. In order to put this into perspective, just consider that all biggest gold mining companies comprising HUI Amex Gold Bug Index have market cap of a little bit over 100 billion dollars now. Compare it to Google’s (NASDAQ:GOOG) 161 billion dollars and the 2.4 trillion of Sovereign Wealth Funds seeking safety from the collapsing US Dollar. Big names in the sector will benefit first: they are on the radar screens of investment banks fighting for the right to advise SWFs. Newmont Mining (NYSE:NEM) could benefit from consolidation by being number 2 in the sector with Barrick Gold (NYSE:ABX) looking for new resources. Silver Wheaton (SLW) has a unique business model of 100% silver revenue stream and fixed cost base, giving the exposure to option on rise in price of silver without time decay. Royal Gold (NASDAQ:RGLD) price action historically precedes a move in gold price and it has recently developed buy signal. Tanzanian Royalty Exploration (TRE) is backed by gold prophet Jim Sinclair and recently has entered into contract negotiations with a company from the People's Republic of China. Riskier plays which could bring more reward will be Mines Management (NYSEMKT:MGN) with silver and copper deposit in Montana and Sterling Mines (SRLM.OB) which is going to produce it's first silver from its Sunshine mine by the year end.

The sector is very volatile and provides one of the best entry points right now after the recent sell off. You should stick with the best names in business who will not put their reputation on the line for a quick buck. Among them is Lundin Mining (LMC), a diversified base metal producer with phenomenal growth. After recent acquisitions, the company with its commodity mix and strong financial position, becomes a very attractive target itself and industry consolidation will drive the share price from recent lows. Voting in confidence of its rapidly expanding business, the Lundin family trust bought 8 million shares in the company during the recent sell off and the share price is fighting its way back now.

The most impressive returns in this major investment trend of the decade will be made in junior mining and exploration companies. Money will infiltrate into this tiny sector from the industry majors rushing to secure promising projects for development of their resource base. Once the dust settles and they understand that demand is not affected by US stagnation or even recession and that financing is available, they will go shopping. The sector is very risky and demands a good industry network and discipline. But once you have found your best shots they will pay off handsomely.