Just two weeks ago, the financial media was buzzing about the U.S. Dollar’s steep decline and surging prices in commodities and precious metals. Last week, the Dollar bounced, trading in a range from 74.4 to 75.8, over 4% higher than the lows visited earlier this month.
From a technical perspective, we wrote in Stock World Weekly (SWW) on April 10, 2011, “The failure of the 76 level concerns us, but with Bernanke signaling his intention to end quantitative easing in June, we think the Dollar is ready to rebound, and we feel it is unlikely that the 72 level will fail to provide support.”
Contributing to the Dollar’s strength, the CME Group Inc., the corporation that operates the COMEX and NYMEX commodity futures exchanges, has been raising margin requirements for silver and several energy products. (Slow Relief at the Pump As Gasoline Decouples From Crude Oil) As Dian L. Chu of EconMatters noted, “Increased margin requirement could trigger liquidation contagion as traders may need to sell their profitable positions in other commodities or equities to raise cash in order to meet the new limits.”
Forcing traders to sell positions to cover margin requirements caused a “Dollar short squeeze” as Wall Street Examiner’s Lee Adler, described it. “Players needed dollars to pay off margin loans. Probably temporary. If the dollar rallies, it means the short squeeze is getting worse.” (SWW: Not Dead Yet, May 8, 2011)
What prompted the CME Group to raise margin requirements? Considering that inflation has become a worldwide problem, it is not farfetched to speculate that the Federal Reserve told the CME group to take action to bring commodity prices down. Bill Schmick, author of the blog “A few dollars more,” posited:
“The Federal Reserve Bank has been targeting asset classes, such as the stock market, in their effort to spark a long-lasting economic recovery in this country. One fly in the ointment has been the spike in commodity prices, especially oil and food, as speculators borrowed money from the Fed at very low prices and made millions by betting on higher commodity prices.
“Oil had reached as high as $112/bbl. and gas prices at the pump were skyrocketing in response. A similar trend was underway in food. The Fed is under increasing pressure and criticism as core inflation remains quite moderate, but consumers and corporations were paying more and more for energy and food (two non-core inflation items). The Fed’s Chairman, Ben Bernanke, has argued that prices for these non-core items are beyond their control. But are they?
“Is it beyond reason to speculate that the CME may have received a call from Big Ben over at the Fed? If the Fed can target an upturn in the stock market, how difficult would it be to engineer a deflating of the commodity bubble through the stiffening of margin requirements?” (A Windfall in Disguise?)
In theory, Bernanke’s signaling that the Fed will allow the second round of quantitative easing (QE2) to end in June, without disclosing plans for QE3, should counter the Dollar’s decline. Without the Fed buying Treasuries via the Primary Dealers (PDs), prices of Treasuries are likely to fall and yields are likely to rise.
The Fed also released a relatively light Permanent Open Market Operations (POMO) schedule for next week. Apparently, the Fed is trying to forestall further price inflation in food and commodities, notwithstanding its ongoing denials regarding inflation.
We have been observing a strong inverse correlation between the Dollar and equities, summarized by our catchphrase: “When the Dollar pops, the markets drop.” The reason is uncertain, and this inverse relationship has not always been the case.
Perhaps it is a function of how the Fed is influencing the markets, with its QE2 scheme of issuing money to the PDs (investment banks, such as Goldman Sachs and JP Morgan) to buy Treasuries; the PDs turn around and flip them back to the Fed. Last week’s POMO schedule prompted Lee Adler to predict, “$11-15 billion in POMO and $16 billion in Treasury paydowns will hit the market over the next two days.
There’s more of a chance that the market will break on Monday [May 16] when the Treasury will settle $68 billion in new notes and bonds.”
Increased liquidity in the hands of the PDs has artificially supported Treasury prices, holding yields down and devaluing the Dollar. Dollars, losing value and earning no interest, naturally flow into commodities – as “speculation” – and equity markets (“risk on” trades).
Washington’s blog estimated that High Frequency Trading accounts for up to 70% of trading volume. (What Percentage of U.S. Equity Trades Are High Frequency Trades?) Are the opposite moves in the Dollar and equities largely due to HFT programs running algorithms that buy stocks when the Dollar drops and sell stocks when the dollar rises? Trader Mark thinks it’s that simple, “If you are bringing anything above and beyond first grade logic to this market, it is too much. It just amazes me that literally armies of PhDs can’t come up with an algorithm a bit more sophisticated than ‘IF dollar zig THEN market zag.'”
If this trading pattern persists, a stronger Dollar would be a bad omen for both equities and commodities. According to Peter Hickson, global commodities & basic materials strategist at UBS, “Momentum is going to be down … if you look at the technicals, I think there’s probably another 10 or 15 per cent down over the next couple of months.” (Commodity Rout Hasn’t Ended, Wait Before Buying: Analysts)
Prices of key commodities are falling. Chinese demand for commodities is slowing, in some cases dramatically. While the nominal value of China’s imports is increasing, this reflects higher prices. Volume data show that Chinese imports of key commodities such as copper, aluminium, soybeans and iron ore have fallen over the last year. (Financial Times – Chinese commodity imports are falling)
The threat that the U.S. government will hit the debt ceiling of $14.3 trillion Dollars loomed over the markets last week. Secretary of the Treasury Timothy Geithner warned of the consequences of inaction in the face of a possible government shutdown. (Geithner warns: Failure to raise debt ceiling may impact seniors.)
Lee Adler commented on POMO, the debt ceiling, and how the government is planning to pay its bills. In his discussion, the term “paydown” refers to a payoff of outstanding debt by the Treasury. It is the return of capital to lenders (investors or holders). With Treasury bills, much of the debt is held by the Primary Dealers, so the paydown results in cash coming back to the PD’s accounts. Lee writes,
“The markets stumbled last week in spite of having plenty of POMO and $16 billion in Treasury bill paydowns on Thursday to stoke the speculative fires. But alas, a minor problem looms. The Treasury will issue $68 billion in net new debt on Monday that the market must pay for. The Treasury says it’s $72 billion…
“Either way, it’s the biggest net settlement since last November 15… So there could be some pressure in [the Treasury] market as well as stocks early in the week ahead. Some of that adjustment seems to have begun on Friday. Paydowns will return next week as only bills will be auctioned. That combined with POMO should give the markets a firmer tone later in the week. Then the supply bogeyman will return going in to the end of the month…
“The Fed’s custodial data on FCB [foreign central banks] holdings through Wednesday suggested that the foreign central banks took their foot off the gas pedal. They had it floored for the past 4 weeks. If this is the beginning of a reversal in their short term buying cycle, that would be bearish for both Treasuries and stocks.
“Supply will be light next week with a net paydown of around $15 billion scheduled for Thursday, delaying the debt ceiling drop dead day to May 31 when the next round of notes, bonds and TIPS will settle. The TBAC [Treasury Borrowing Advisory Committee] says that will amount to $61 billion. This thing is up to John Boehner now. Like Newt’s great political blunder in 1994, will this be Boehner’s boner? It’s in his hands.” (Lee Adler, Markets Look to Boehner)