Federal Reserve & Interest Rates

The price of crude oil has continued it’s downward trend into September as Mother Nature and foreign conflicts have only been able to stall it’s decline over the past three weeks.  We saw oil try to rally on a couple of occasions since it fall from it’s mid-July record of $147.

The outbreak of hostilities between Georgia and Russia which put at risk a major oil pipeline only caused a minor hiccup.  Fears of offshore drilling disruptions from Hurricane Gustav saw oil prices shoot up $6 dollars in one day only to fall by the same amount the following trading session.

The rise of the dollar has played a large part in the general retreat in the commodities market.  After falling to record lows that coincided with oil’s record highs, there is a real feeling that we could be seeing the dollar beginning a period of renewed strength.

This a highly volatile market with large movement swings happening in both direction.  We could easily see oil try to rally again if hurricane activity threatens the Gulf Coast drilling sites.

The same could be said about the dollar, no one knows how it will react in the upcoming months and if it starts to fall again we could see a lot of traders jumping back into commodities.  Analysts are carefully watching the European markets, as long as their economic growth lags behind ours, the dollar should gain in strength.

Central banks will also play a major role as the relative interest rates of each country are a large factor in exchange rates.  At the moment the Fed is more interested in economic growth, while the EU has maintained it stance against inflation, as for Japan, their interest rates are even lower than ours.

Has the oil bubble burst for good?  You still have a lot of traders out there who think oil can recover and break $150 by the end of the year.  Hopefully it will fall to $80, which oil producers believe should be it’s normal price range.

The underlying reason why commodities have retreated in the past month is that the dollar has experienced a resurgence in currency markets.  Currency experts feel that the dollar is ready for a period of renewed strength after years of bearish sentiment.

Weakness in foreign economies has increased demand in the greenback as it is looking like the European Union is in the midst of a recession.  Recent data showed that the EU economy actually contracted last quarter.

Taken with the fact that earlier this week the Commerce Department revised GDP upwards for the second quarter the Fed is more likely to raise interest rates before the European Central Bank(ECB) will.  The ECB has maintained it’s strict stance on price stability but many analysts feel it will eventually have to reverse it’s course from last month, after it raised rates by a quarter percent.

There could well be a strengthening synergy effect between the dollar and oil.  As the dollar gains and oil falls it lowers inflationary pressure across the globe and will take some of the pressure off the ECB to maintain higher interest rates and could give them some leeway to deal with contracting economic growth.

However, the same case could be made for the Fed, there is much less pressure on them to raise rates than there was two months ago and the Fed Chairman feels inflation will continue to moderate into 2009.  The Fed is still concerned with troubled financial markets but the upsurge in GDP is definitely a welcome sign.

If the dollar does go on a sustained run it could be rough times ahead for exporters and the foreign growth potential of multinational corporations particularly the tech sector.  Trade and tech have been a some of the few bright spots during this long economic slowdown.

Although the decline in the price of oil is getting most of the attention, commodities have been retreating across the board for the last two weeks.

“People have gotten very worried about demand for commodities because of this global meltdown,” said Michael K. Smith, president of T&K Futures & Options in Port St. Lucie, Florida. “If all these major economies are going to slow down, people think that’s really bad news.” 

When the dollar started it’s free fall last year and inflation started to rear it’s ugly head, we saw large amounts of institutional money pouring into the commodities market.  Commodities were one of the few outlets for investors that provided decent returns with the bond, stock and housing markets all in decline.

So much money went into these markets over such a short period of time, a speculative bubble couldn’t help but form.  Unfortunately with the economic troubles that began in this country slowly spreading around the globe, that bubble is starting to burst.

On one hand it seems as if some of the inflationary pressures are starting to abate, which is the good news.  On the other hand, the reasons for this is not because conditions are improving in this country but that the rest of the world is falling to our level.

For example the dollar has been gaining in exchange markets recently but instead of thinking of the dollar as growing in strength, it’s more like foreign currencies are weakening with their respective economies.  Consider that interest rates in the U.S. are comparatively lower than much of the world, which serves to drive down demand for dollars.

If commodities continue their fall, it would allow the Fed to maintain interest rates at their current level and allow more time for financial markets to recover.