Commodity currencies, such as the Australian and the South African rand, which have strong ties to base metals and gold, are under selling pressure, and the Canadian Petro-dollar is losing its luster, due to sharply lower oil prices. Gold and silver have been held hostage to crude oil, and many traders are wondering whether the latest plunge in oil is linked to US election politics.

But with the Reuters Commodity Index (CRB) flirting with the psychological 300-level, led by crude oil, copper, and gold, the big unresolved questions are (1) whether the sharp drop in commodities is heralding the onset of a major global economic downturn, led by the US housing market, or (2) maybe just a speculative shakeout, and if so, (3) how long will the latest shake-out in commodities last?

(## press down on the control key and click on link below to hear an October 6th interview with Mr. Dorsch, who answers questions on the global economy, gold, crude oil, interest rates, stock markets, and foreign currencies).

www.fantalklive.com/archives/TBF_10052006.mp3

Until recently, the Reuters Commodity Index was tracking the MSCI World Index for the previous four years, led by a 5% growth rate for the global economy, and surging demand for raw materials in China and India. Commodities typically rise when global growth and consumption are strong and decline when the world economy sinks. If so, the recent plunge in commodities might suggest the global economy is in for some rough sledding in the months ahead.

Global Capital Markets Celebrate Lower Oil prices

However, stock markets in major oil importing nations, such as Germany and the US, are singing a happy tune, celebrating the latest 20% energy tax cut. The sharp decline in crude oil prices from $75 to $60 per barrel, if sustained, would cut the US oil import bill by roughly $4 billion per month and the German import bill by $1 billion /month. German and US bond yields have also dropped by 40 to 60 basis points since mid-July, as inflation pressures receded due to sharply lower oil prices.

The latest plunge in the Reuters CRB Index also highlights the wizardry of central bankers over global markets, when they act in lockstep for a common goal. By tweaking their short-term rates higher, central bankers from a dozen different countries, succeeded in frightening commodity speculators, but lifted the spirits of bond and stock market traders. The debate in the US bond market has now shifted to when the Federal Reserve will start lowering the fed funds rate.

The recent slide in crude oil prices to 7,000 yen per barrel has eased inflation fears in the Japanese bond market (JGB's), knocking the 10-year yield from 2.00% in mid-July to as low as 1.62% last week. Japan's new prime-minister, Shinzo Abe is opposed to further BOJ tightening moves. "Increases in interest rates would have a big effect on the government's debt interest payments. We have to keep a close watch on their moves."

Japan has 765 trillion yen in sovereign marketable securities, or $6.5 trillion, outstanding, compared with $4.3 trillion in the US Treasury market. The latest 0.3% drop in 10-year JGB yields lowers Tokyo's debt-servicing costs by 480 billion yen ($4.1 billion). The latest 20% drop in world oil prices also reduces Japan's oil import bill by $1.9 billion per month. However, Japanese banks, which own 140.4 trillion yen ($1.24 trillion) of JGB's, might unload some JGB's, if crude oil holds support at 7,000 yen /barrel, and rallies higher after OPEC lowers oil output.

The Evaporation of the Iranian "war premium"

In retrospect, but the plunge in crude oil from $75 per barrel to $60 /barrel, is linked to the evaporation of a $15 per barrel Iranian "war premium," that was built into prices earlier this year. The energy sector, including crude oil, unleaded gasoline, heating oil, and natural gas, accounts for 39% of weighting within the Reuters CRB index. Thus the post August 8th plunge in the CRB index is probably a speculative blow-out of over extended long positions in crude oil, base and precious metals.

The majority of oil traders now think the Bush administration is just a "paper tiger", and has discarded the military option against Iran. Instead, mired with a 37% approval rating, President George Bush appears resigned to a protracted diplomatic process with Tehran, and dabbling with cosmetic sanctions that have little potency. So without the credible threat of a US military attack on Iran, energy prices began to feel the gravitational pull of hefty US energy stockpiles.

US crude oil inventories rose to 8-year highs of 346.7 million barrels in April 2006, yet crude oil prices continued to climb towards $80 per barrel. US oil companies were hoarding oil, worried about supply interruptions from unstable places, such as Iraq, Iran, Nigeria, and Hugo Chavez's Petroleos de Venezuela. Yet the last time US oil stockpiles were as high as 346.7 million barrels, the price of crude oil was trading between $15 and $20 per barrel in 1998.

Testing the Resolve of the OPEC Cartel

On Sept 22nd, Saudi oil chief Ali al-Naimi tried to stabilize oil prices at $60 per barrel, with verbal jawboning which sparked a brief bounce to $64 per barrel. "Prices now are rewarding to both producers and consumers and their impact on the global economy is small. The most important gauge for this price is that it does not have a big negative impact on the global economy," said Naimi. But the rebound was short-lived, and oil prices were again sliding under $60 per barrel a few days later.

But on October 4th, Kuwaiti Oil Minister Sheikh Ali al-Jarrah al-Sabah indicated the oil kingdom might join Nigeria, Iran and Venezuela in cutting its oil output if prices continue their steep drop below $60 per barrel. "Kuwait may voluntarily lower oil output in order to maintain the market's stability. We are currently in negotiations with fellow OPEC members. The current situation with prices and the big retreat that has taken place is uncomfortable for OPEC nations," al-Sabah added.

The Kuwaiti oil minister said "$60 per barrel for US light crude is a comfortable price, but $50 /bl is worrying." On October 8th, following an extra ordinary telephone conference, OPEC agreed to a deal to remove 1 million barrels a day of crude from oversupplied markets, as ministers lined up to support the cut. Iran and Algeria publicly backed the reduction, OPEC's first since December of 2004.

Election Politics and Crude Oil

It is interesting to note, the last time OPEC cut its oil output in a meaningful way in December 2004, was to defend US oil prices from falling under $40 per barrel. Today, OPEC seeks to stabilize crude oil prices at $60 per barrel. Despite the 50% increase in oil prices since October 2004, the Dow Jones Industrials is 20% higher. OPEC knows the world economy can expand at $65 to $75 per barrel, so the cartel doesn't see any reason why prices should fall too much further.

Do oil prices and election politics go hand in hand? In the last run-up to US elections in 2004, a surge in crude oil prices from $44 per barrel on Sept 16th 2004, to as high as $55.25 on October 26th 2004, had knocked the Dow Jones Industrials 500 points lower to the 9750-level, and according to CNN polling data, President Bush's 7% lead over John Kerry soon swung into a 3% deficit.

For much of 2004, gyrations in the stock market revolved around polling data. When Kerry pulled ahead of Bush, the stock market turned lower, and vice versa. When the Dow Jones Industrials fell below the psychological 10,000 level to as low as 9750 in October 2004, with only 7-days left before Election Day, the Kerry camp was jubilant, since Wall Street pros were apparently pricing in a Bush defeat.

But fortunately for Bush, the price of crude oil did a 180 degree reversal, and tumbled 10% to $49.50 /barrel in the final week before the elections. The Dow Industrials rebounded above the 10,000-level, viewed by pollsters as Wall Street's red line between a Bush or Kerry victory. The last minute drop in crude oil, combined with a Dow rally, might have helped Bush to a 51% to 48% popular vote victory.

Republicans trying to hold onto their seats on November 7th are also hoping for a bit of good luck. Will a 70 US-cent per gallon drop in gasoline prices, and Friday's report of a 4.6% US jobless rate, the lowest in 5-years, do the trick in 2006?

Gold market held Hostage to Crude Oil

Since peaking at $675 per ounce on July 14th, three rally attempts by gold bugs have fizzled out, and were ultimately wiped out by sliding oil prices. On October 3rd, gold briefly fell below $570 per ounce, after crude oil tumbled below $60 per barrel. Gold was also spooked by fears that European central bankers would dump 180 tons of gold from mid-July until Sept 26th, to meet their full quota of 500 tons per year.

Instead, the European central banks limited their sales of gold to 73 tons on the spot market in the final two months, for a grand total of 393 tons, falling short of their full quota for the first time since 1999. But the London Telegraph published an October 7th reporting that the Bank of France sold up to 100 tons of gold through forward contracts in September, knocking the yellow metal below $600 per ounce.

Amaranth Advisors, a hedge fund manager lost billions of dollars in energy trades in the summer, and was liquidating its remaining positions at fire-sale prices. Amaranth incurred a $6 billion loss in wrong-way bets on natural gas derivatives, including $560 million in one day alone. Aramanth's dumping of energy contracts indirectly contributed to gold's slide towards its June lows.

At the moment, the gold market is hovering above $570 per ounce, supported by signals that OPEC intends to cut its daily oil output to defend the US crude oil price at $60 per barrel. Gold's initial reaction to Pyongyang's detonation of a nuclear bomb was muted, gaining just $3 /oz in New York, after trading $10 /oz higher in Asia. Nowadays, geo-political tension only seems to benefit gold, when it involves a major oil producer, such as Iran, and impacts the price of crude oil.

Pyongyang Detonates the Bomb, Jolts Korea and Japan

Three years of six-party talks with Pyongyang, simply led to North Korea's detonation of a nuclear bomb on October 9th, 2006. It's no secret that North Korea has a small arsenal of nuclear weapons, but it was a bit of a surprise to see Kim Jong-il actually pull the trigger. China has been North Korea's main supporter, since its army saved it from defeat by US forces under a UN flag in the 1950's. Beijing provides 90% of N Korea's oil supply, estimated at one million tons per year.

But this time, China might have overplayed the North Korean card. The specter of an Asian atomic arms race now looms over the region, and Beijing could find itself surrounded by neighbors in Japan, South Korea, and Taiwan moving to join the elite club of nuclear powers. Japanese prime-minister Shinzo Abe, a staunch North Korea critic, wants to amend the Constitution to give Japan's military greater leeway to go nuclear, and it won't take long to convert its huge stockpile of plutonium.

But traders in South Korean stocks and the won have prospered under the dark shadow from the North, since Pyongyang first disclosed its nuclear arsenal to the world in April 2003. The Korean Kospi index has more than doubled from 3-½ years ago, while the US dollar has plunged by 250-won, or 20%, during the same time period. In the past, sell-offs ignited by worrisome news from Pyongyang, were simply new buying opportunities at cheaper prices for foreign and local investors.

Kospi blue chips and the Korean won were initially rattled by Pyongyang's detonation of the nuclear bomb. On October 9th, the benchmark Kospi Index lost 2.6% to the 1,316-level, after falling as much as 3.6% earlier. The US dollar jumped 15-Korean won to close at 964-won in Seoul, and gained 1.30 Japanese yen to 119.08-yen.

But a sense of calm prevailed the very next day, with the Kospi recovering 0.6% to the 1328-level, after learning that foreigners rescued the market with net purchases of 496 billion won, their largest one-day purchase since April 11th. The sudden interest in Korean stocks by foreigners was surprising, since they had sold a record 9.5 trillion won of Korean stocks between May and September, lowering their exposure by 5% to 38% of the market's capitalization.

Kim Jong-il has called Washington's bluff, betting that the crisis it has created by testing a nuclear weapon will bring pressure on the US to abandon its own refusal to deal directly with North Korea. Traders are also betting that a diplomatic solution can be reached, after Pyongyang offered to abandon its nuclear program, in return for financial and security guarantees from Washington.

And behind the scenes, the Bank of Korea is tolerating a 9.2% annualized growth rate for its M2 money supply, the fastest gain in nearly 3-½ years, to buoy Kospi stocks and to counter US dollar weakness against the won. The BoK is expected to leave its loan rate unchanged at 4.50% on October 12th, to soothe jittery markets.

All Eyes on US Economy and Housing Sector

Despite the euphoria of a new record high for the Dow Jones Industrials, the US economy, which accounts for 28% of global economic output, is at risk from a weaker housing market. The pace of existing US home sales fell for a fifth straight month in August, hitting a 6.3 million unit annual rate. US home prices fell to $225,000 in August, or 1.7% lower from a year earlier, the first annual decline since April 1995. The inventory of existing homes for sale rose 1.5% to 3.92 million units, or a 7.5 months supply, a 13-year high.

A year ago, homeowners were enjoying double-digit price gains and were tapping voraciously into their home equity to finance spending. In 2005, refinancing and cash outs against home equity totaled $550 billion, and exceeded the US after-tax gains in wages of 375 billion. Any back-to-back decline in home prices of more than two months would be unprecedented in the US, and could indicate a deep slump in the housing market and consumer spending that could take several quarters to play out.

"I would estimate that slowing housing construction will probably take about a percentage point off growth in the second half of this year and probably something going into next year as well," said Fed chief Ben Bernanke on October 6th. But the Fed is not expected to cut rates in the fourth quarter to support home prices. "The inflation rate is still above what we would consider price stability," Bernanke added.

"The housing sector is going through a painful, but necessary, adjustment and has slowed overall growth somewhat," said Philly Fed chief Charles Plosser on October 5th. "But the expansion is still on firm footing and growth is likely to accelerate in 2007. We need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy's long-run performance," said super-hawk Plosser. "The predominant risks facing the economy now are on the inflation side."

China's Economy is linked to the US housing market

China's economy expanded at annual rates of about 10% between 2002 and 2005, a period corresponding with booming Chinese exports to the US, and turned China's economy into the fourth-largest in the world by the end of 2005. But if the US housing oversupply is met by a too-tight Fed in 2007, it could weaken US demand for Chinese imports, and submerge Chinese economic growth into single-digits.

Beijing has relied on exports, primarily to US consumers, to drive its double-digit economic growth. Between 2001 and 2005, China's average annual rate of export growth was 25%. Exports grew by 35% in 2004 and 28% in 2005. Including goods re-exported from Hong Kong, exports to the US accounted for 50% of total Chinese exports. Thus, Chinese export growth is largely determined by US demand.

Exports accounted for 40% of China's economic growth in 2005. And because almost all of China's exports are consumer goods, external demand also plays a key role in the growth of foreign investment in China. Foreigners invested $73 billion in new factories and other investments in China over the past 12-months, and the global economic outlook could impact up to 65% of decisions for new expenditures.

Thus, a US economic downturn in 2007, could have a strong negative impact on China's economy, and rattle other Asian exporters in Australia, Japan, and South Korea. The chain reaction of a US economic downturn could also be felt worldwide, when one considers that 20% of European exports are earmarked for the US, and China's sales of 86.9 billion Euros in the first six months made it the #2 exporter to Europe, just under the US's 89.8 billion Euros.

No Early Signs of a Chinese Economic Slowdown

Yet despite recent monetary moves by Beijing to rein in its M2 yuan money supply, there are scant signs of a slowdown in China's booming economy or stock markets. China's purchasing managers' index rose sharply to 57.0 in September, compared with 53.1 in August, signaling accelerating in growth in the manufacturing sector. The backlog of new orders was 10% higher in September from July.

Mainland China's exports rose to a record $90.77 billion in August, up 32.8% from a year earlier, helping the Hang Seng China Enterprises Index, which tracks 37 mainland companies, to close at 7128 on October 6th. Hong Kong stocks closed at fresh six-year peaks on October 5th, fuelled by a record high in the Dow Jones industrials, and global bellwether HSBC Holdings #5.HK, hit an all-time high.

Hong Kong purchasing managers' index (PMI) also rose to 53.7 in September, the highest reading since May, from 51.6 in August, and marked the 21st straight month of expansion. Exporters stepped up hiring to cope with new orders from mainland China. Global demand for high-technology products made and assembled in Asia, helped Hong Kong's key re-export trade. Almost 95% of Hong Kong's exports are re-exports of goods made elsewhere, often in mainland China.

10 October 2006

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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

Disclaimer: SirChartsAlot.com's analysis and insights are based upon data gathered by it from various sources believed to be reliable, complete and accurate. However, no guarantee is made by SirChartsAlot.com as to the reliability, completeness and accuracy of the data so analyzed. SirChartsAlot.com is in the business of gathering information, analyzing it and disseminating the analysis for informational and educational purposes only. SirChartsAlot.com attempts to analyze trends, not make recommendations. All statements and expressions are the opinion of SirChartsAlot.com and are not meant to be investment advice or solicitation or recommendation to establish market positions. Our opinions are subject to change without notice. SirChartsAlot.com strongly advises readers to conduct thorough research relevant to decisions and verify facts from various independent sources.