Federal Reserve & Interest Rates

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.

Oil continues it’s meteoric rise this year as it passed the $135 a barrel mark earlier today.  The debate has been raging whether the high prices are the result of a speculative bubble or normal supply and demand interaction.

I believe it is a combination of both factors.  World wide demand has grown sharply the past few years as the developing countries become more and more industrialized.  That being the case, that still doesn’t justify the more than 30% rise in the price of oil for this year alone.

Last summer, oil was trading at around the $60 a barrel range before the Fed began it’s rate slashing campaign and the dollar took a nose dive.  This put a large upward price pressure on all dollar denominated assets. 

Money started pouring into the commodities markets as inflation hedges at the beginning.  When the stock and bond markets started falling, the commodities market offered better returns and large institutional investors also started to enter the fray.

But as world wide economic activity has slowed due to the global credit crunch, demand for oil has fallen somewhat, but the price of oil has continued to rise.  While some of this is due to inflation, that would still only justify somewhere between 5-10% of the price rise since last summer.

The price of the dollar is the key to the price of oil.  While the administration is supposedly in favor of a “strong” dollar policy, the Fed’s top priority remains economic growth with inflationary concerns a distant second.

That mind set may be slowly changing and it would be interesting to see what effect a rise in interest rates would have on the price of oil.