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Evaluating the USD, Interest Rates, and Commodities

In a report put out by Barclays called, “It’s Not Just the Dollar Stupid”, Barclays argues that “from time-to-time market commentators can become focused on certain relationships to the point of obsession. So it is with commodities and the value of the USD at present. Price moves of varying magnitudes in markets as diverse as oil, soybeans, gold and copper are all being attributed to recent fluctuations in the value of the US dollar, with very few other factors given much attention or significance. This obsession with currencies risks obscuring the important developments in fundamentals that is far more significant in determining and differentiating commodity market trends.”
Yesterday, I found myself scratching my head profusely trying to figure out what the heck everyone was thinking with respect to currencies, interest rates, stocks and commodities. The logical argument presented yesterday was that interest rates moved up across the curve which led to a reversal in the USD decline against most other currencies which then took a negative toll on stocks and commodities alike. Does this make any since?
Well, yes the USD has been on a relatively persistent decline against many other currencies. And yes, this has coincided with an appreciation of most commodities (and stocks). But, “the flow of economic and fundamental data are improving fast in many commodity markets and that this is as important, if not more so than dollar trends. The past two weeks alone have brought much stronger-than-expected Chinese commodity import data and a raft of impressive statistics on GDP, IP, fixed asset investment and retail sales. Market specific data are also improving: for example in oil, where the trend of diminishing US inventory overhang has continued and the trend of improving global oil demand is very much intact. Supply issues are also exerting an important influence. In grains, bad weather is leading to huge delays to the US harvest, while in copper, a combination of strikes and technical problems are causing a significant re-assessment of the production outlook.”
It appears that most of the fundamental factors underlying commodity markets have taken a back seat for the time being. So what gives? The pro-dollar argument is that interest rates rising will put significant pressure to the shorts as new money floods into U.S. Dollars which will put significant downward pressure on commodities (and apparently stocks) if recent history is any guide. Wait a minute! Does that make sense?
This is empirically false. Furthermore, this argument doesn’t even make economic sense. What exactly do people think causes higher interest rates across the curve? Yes, the short end of the curve can be impacted by the Federal Reserve. However, the long end of the interest rate curve is determined by the global supply and demand of capital. As capital becomes dissuaded from or even flat out weary of the safety and value of United States Government securities, capital begins to flow away from the United States–which in fact causes interest rates to rise. Case in point…if China finally began to diversify away from the USD, they would stop buying treasuries which would necessarily put upward pressure on interest rates until enough additional buyers came in to fill the void created by the lack of new Chinese demand. So, as investors listen to pundits claim that higher interest rates will lead to the USD reversing its decline…please keep in mind that that logic is actually a fallacy. 

Where would the new demand for USD come from? As far as I can tell there is no new source of demand (increases the demand for USD) to offset the capital outflow (increases interest rates) that would occur leading to interest rates increases.  Although it is worth mentioning that the increase in the U.S. savings rate does help keep interest rates pushed down to some extent, though it is not nearly enough pressure to counteract any lack in Chinese demand for U.S. Treasuries.  Furthermore, an increase in U.S. savings rates should not result in a higher value for the USD since domestic savings is already denominated in USD. 
So now empirically debunking this horrible theory... 
I am most interested in countries like Australia, Canada, and Brazil.  I just decided to pick a few commodity oriented countries. The three charts shown below are the respective exchange rates of each commodity producing country I am interested in, compared to the U.S. 30 Year Treasury Bond yield. It is easy to observe a positive correlation between the yield on the 30 year bond and all three foreign currencies. Let me characterize this relationship in words…As interest rates rise, the U.S. Dollar declines relative to the currencies of all three commodity producing nations. As I argued above, capital is flowing out of the United States to other homes including Australia.   

In my opinion there are two fundamental reasons this relationship exists. First of all, the direct capital outflow theory in which capital is actually flowing away from the U.S. and into these other countries-which causes U.S. interest rates to rise simultaneously causing the value of the U.S. Dollar to decline in value relative to these other country’s currency, respectively. Secondly, I would argue inflation risks. 30 Years is a very long time to wait for the return of one’s capital. One of the very first things business students are pounded with in school is time value of money. In essence we know that in an inflationary environment, money 30 years from now is not worth what it is today. As such, there is an extra inflation premium built into the 30 year bond price which translates into a higher yield compared to shorter term investments i.e. the 2 Year Treasuries. 
What is inflation? Inflation could be simply defined as the increase in the price level of an economy. In an inflationary world everything becomes more valuable except for money. Things like oil, natural gas, agricultural products like corn or orange juice, metals like copper, nickel and gold all become more valuable while money becomes less valuable. What do all these countries have in common? They produce stuff like oil, copper, gold, uranium, and a bunch of other commodities. Quite simply, these countries are rich in natural resources.  And empirically, when U.S. interest rates rise the currencies of these countries become more valuable compared to the value of the U.S. Dollar.  
Why are some people thinking that the USD decline will be reversed if interest rates start to rise? Who knows…but they will likely be proven wrong. The USD might very well reverse its decline in the short run but longer term, who in their right might is bullish the USD? I cannot think of a single positive factor that leads to a bullish dollar case. Of course, this is the same logic that gets people violently destroyed in the market because the market itself becomes so incredibly skewed to one side. Awe, there it is. The most crowded trade as of late is quite clearly bearish the U.S. Dollar. In my opinion, the shorts getting modestly squeezed and shaken is what caused yesterday’s commodity debacle. This could get much worse before it gets better. But eventually, those with a longer term outlook will be proven right. The path of least resistance will once again be taken. Inevitably, the USD will once again continue lower. This has one or two HUGE caveats. If the fiscal house of the United States government, businesses, and households is put into order, the USD can actually start a legitimate fundamental recovery against other currencies. Until that day comes, this anomaly of higher interest rates coupled with a higher USD, should be seen as a buying point for long term investors to make their way into commodity related industries.
The reality of the situation is that higher interest rates are without question somewhere on the horizon. That is not because the outlook for the United States is rosy. On the contrary, higher interest rates in the future will be a direct result of decades of bad fiscal policy and extremely “easy” monetary policy. Don’t buy into the argument that a strong U.S. Dollar will likely coincide with these upward moving interest rates.   
Author is long FCX, PCU, VALE, PSEC, ETV, and AGCO