Oil futures surged to a record intraday high of $70.85 on August
30th, the day after Hurricane Katrina made landfall on the Gulf
Coast. While prices have moderated in subsequent weeks, it's
worth examining how higher commodity prices and the specter of
inflation impacts the foreign exchange (FX) market, particularly
the U.S. dollar.
Traditional supply and demand factors certainly have contributed
to the longer term trend in energy prices. The demand side of
the equation has been getting plenty of press this year, with
focus on the rapidly growing thirst for oil in both China and
India. However, the recent spike in oil can primarily be
attributed to hurricane related speculation in the futures
market and the limited and centralized (on the Gulf Coast)
refining capacity of the U.S.
Economic data released in recent weeks has begun to reflect the
effects of hurricanes Katrina and Rita, which ravaged the U.S.
Gulf Coast in August and September. These data reinforce what
the Fed has been implying all along; that the economy is growing
at a brisk pace and that inflation, not recession, should be the
concern.
September jobs data showed the first net job losses since May of
2003, but the decline of 35,000 jobs was much smaller than the
decline that was anticipated. September CPI showed the largest
monthly gain in 25 years. However, when the volatile food and
energy components are removed, inflation was a rather mild 0.1%.
That was quite a bit less than the market was anticipating and
suggests that the higher energy prices are not being passed
through to the core number yet.
Similarly, the September PPI headline number exceeded
expectation and was the largest monthly gain in 15 years.
However, again we remove food and energy and see that wholesale
prices were up a relatively restrained 0.3%. This core number
did beat expectations though, so one might deduce that higher
energy prices are starting to impact prices at the wholesale
level and it's just a matter of time before these higher prices
are passed along to consumers. Weaker than expected retail sales
and a new 13 year low in Consumer Sentiment suggests that higher
energy prices are indeed weighing on the American consumer's
mind. How that will play out, particularly in the retail sector
going into the holiday season is now a major focus on Wall
Street.
With the word 'inflation' seemingly on everyone's lips these
days, we expect the Fed to continue on its tightening schedule.
The Fed raised the target for overnight borrowing in September
by 25bp to 3.75%, the 11th such hike since June of 2004. Another
rate hike is expected in October and at least one additional
25bp bump is all but assured in November or December.
Rising U.S. interest rates and an expanding U.S. economy have
been the driving forces behind overseas flows into U.S
treasuries and the stock market respectively. These flows
translate into demand for the U.S. dollar, which has kept the
greenback generally well bid in September and October. While we
would contend that the equities market is vulnerable at this
stage, the interest rate differential picture should continue to
favor the dollar through year end.
High energy prices and inflation fears are not exclusive to the
U.S. Central bankers and finance ministers from the Group of 20
industrial and developing nations are meeting in Beijing this
month. A statement released on October 16th said, high oil
prices "could increase inflationary pressures, slow down growth
and cause instability in the global economy.' This should
benefit the dollar as well because in times of global economic
uncertainty, the dollar is still considered a "safe haven"
currency. While we may see other countries begin to tighten
their monetary policies, U.S. interest rates will remain
significantly higher.
The definiteive move above USD-JPY 115.00 bodes well for
additional dollar gains against the yen into the 118/120 zone.
On the other hand, the July lows in EURUSD at 1.1868 must be
convincingly negated to trigger further dollar gains against the
European currency. Such a move would shift focus to the 2004
lows at 1.1759/78 initially, but potential would be for a drop
below 1.1500.
In times of inflationary pressures, the U.S. dollar tends to
lose ground against the commodity currencies. Commodity
currencies are the currencies of countries that derive the bulk
of their export revenues from the sale of commodities. Prime
examples of liquid commodity currencies are the Canadian dollar,
Australian dollar and New Zealand dollar.
The dollar hit a new 17 year low late in September against the
Canadian dollar on the back of sharply higher oil and metals
prices. While the dollar recovered from those lows, gains are
considered corrective in nature and we look for the longer-term
downtrend in USD-CAD to continue. Similarly, AUS-USD and NZD-USD
are consolidating below important resistances with scope seen
for additional short to medium term gains.
At some point, domestic inflation and the rise in the U.S.
dollar will return focus to the U.S. trade deficit and balance
of payments. As U.S. goods and services become more expensive,
both domestic and overseas consumers will look elsewhere. That's
the point where the U.S. stock market truly becomes vulnerable.
Downside risk in the stock market will result in a negative
impact on flows into the U.S. and consequently the long-term
downtrend in the dollar would likely start to re-exert itself.
Conventional wisdom in the financial services industry suggests
that placing 5-10% of one's portfolio in alternative
investments, such as those offered by CFS Capital, is desirable
to achieve the diversification necessary to protect against
adverse moves in the more traditional asset classes.
For daily Forex market news and insights visit the CFS Capital
Blog (
http://www.cfscap.com/blog/index.html )
Peter Grant VP of
Operations
CFS Capital Management Forex Market News
and Insights Blog
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