The Declining Dollar and New Trading Opportunities
By Al Martin

(9-24-07) The dollar fell back last week about 100 basis points, as measured by the NYBOT dollar index, which is about what the dollar should have fallen back to immediately reflect the half a point cut in the Fed funds rate.

However, commodity prices were initially slow to respond to the dollar decline, and really did not start to respond in earnest until Thursday and Friday. Indeed it is a misnomer to think that commodity prices can simply rise indefinitely because the value of currency in which they are trading is depreciating. That is an oversimplification, and indeed there is no direct correlation.

The reason why the correlation is not direct is because of the supply/demand curve. The underlying supply/demand curve prevents a commodity from being priced too high, no matter how much the value of the currency it’s being traded in is depreciating, simply because you can’t create any more demand for the underlying item through a depreciating currency.

Commodity prices rose as they should have as the dollar declined. It’s the way it’s supposed to work.

Gold did finally respond but not in earnest until the last phase of the week, reaching nearly $750 in the GCZ contract. However, do not think that all commodities are going to be immediately and consistently pressured higher simply because the dollar is falling.

For instance, the declining dollar has much less of an impact in fungible commodities than it does in a monetary asset such as gold. Why? Because fungibles have a direct supply/demand curve that gold doesn’t have because fungibles are ultimately consumed.

You can’t simply create more demand for soybeans to justify a higher price for them simply because the value of the currency they are trading in declines. Why? Because eventually the old market adage that the best cure for high prices is high prices sets in.

We have already begun to see this in the wheat market and the cotton market, where demand for these commodities is falling simply because their prices have risen to a point where the purchase of them by suppliers and users, those that turn these products into other things that are then resold to the public, become a losing proposition because the ultimate prices of the items, the goods that these raw commodities get turned into, cannot be increased as quickly at the retail and wholesale level as the value of the raw commodity is rising.

The reason why it’s a trading opportunity (old-timers on the floor always say this, and it’s true) you want to short dollar-generated rallies. And they’re right because dollar-generated rallies aren’t sustainable rallies because they’re not being created through any underlying change in the supply/demand equation of a fungible commodity.

Therefore, sharp dollar-driven rallies in fungibles create short-selling opportunities. Indeed, you only need to look at the wild trading action in the cotton this week to see what I mean, where the CTZ contract rose to a new near-term high above 66 cents, and collapsed down to 63½ cents overnight, constituting a key reversal.

Despite the fact that cotton has risen again, technically speaking, the back of the cotton market has been broken.

Cotton was a pretty good example this week of a dollar-driven rally, wherein the price of the item was driven up to the point that it was too far ahead of its underlying supply/demand equation, in which case, you saw a sharp break.

In short, dollar-driven rallies in fungibles create short-selling opportunities because they cannot be sustained in that they do not change the underlying supply/demand equation.