Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months. 

How do the major oil companies navigate their way from currently searching for, pumping, refining and finally selling oil & gas to consumers to a world which will eventually have to learn to survive on energy from another source.  What is a sensible price (or p/e ratio) to pay for a major Western oil & gas company whose principal line of business will disappear at some point in the future?

At some point in the future the supply of oil & gas will become increasingly restricted (proponents of the Peak Oil theory believe that world production levels have already peaked and are now on a declining trend). Long before we get to a situation where Saudi Arabia and Gazprom/Russia have a stranglehold on oil and gas respectively, the rest of the world will have to have moved beyond petroleum and onto a different resource for their everyday energy needs.

The most likely source of the R&D funds to seek out new types of energy are Western governments and the oil majors themselves; the latter are fully aware of their need to diversify away from oil & gas or else end up being convenience store operators on the sites of their (former) petrol stations.  Just how much money gets thrown at this particular problem is likely to be directly correlated to the oil price (if oil is cheap & plentiful then there is no pressing need to hurry up and research its replacement).

Does this mean we should all sell our shares in BP, Shell and the other oil majors immediately? No.  As with most blue chips, the most sensible investing strategy is to play the trading ranges within a diversified portfolio.

However sensible portfolio diversification means not having too high a percentage of your portfolio in oil & gas companies.  Having no exposure makes no sense either because then you would have nothing to sell if the price of oil suddenly rockets for whatever reason (one oil-price-spike scenario the doomsters love is where the US gets Israel to bomb the Iranian nuclear reactors/processing plants and Iran closes the Strait of Hormuz in retaliation – 90% of the oil exported from the Persian Gulf passes through the Strait of Hormuz on oil tankers).

As a happy side-effect, when the world does eventually move beyond petroleum, carbon emissions will presumably fall off a cliff (millions of petrol-powered cars will no longer emit CO2) which will keep the global warming crowd happy and they will be able to move on to worrying about something else which is of more immediate interest to mankind (they can take their pick from : global poverty, hunger, malaria, girls’ education in the Third World, etc.).  Hopefully the entity which discovers the world’s next source of energy will engage with their charitable side and donate some of (what will undoubtedly be) their enormous future profits to one of these projects; echoing what happened when petroleum succeeded whale-oil and John D. Rockefeller donated some of his Standard Oil fortune to philanthropy.  To this day, ExxonMobil (which is essentially formed out of two of the companies which Standard Oil was broken up into in 1911) is still the most valuable company in the S&P 500 and XOM paid out over $8 bln in dividends last year.