Energy Prices, Inflation and Forex

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 definitive 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.




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