Last month, my big-picture themes for traders were to keep your eye on the U.S. dollar, and also China. These remain driving factors this month, too. But now, in early August, one major trend has changed: commodities are no longer going through the roof and are in midst of some notable corrections. Now everyone is wondering whether the commodity bull market has ended, and inflation is no longer a fear.
China has been a driving force in the global economy, and in demand for commodities. As China prepared for the summer Olympics, it was like the girl going to the prom. She had to get her dress, to look pretty. China had to spend money on infrastructure, food, and energy. Manufacturers had ramped up spending to produce and warehouse supplies ahead of the games. According to an Associated Press report, it was estimated the government was spending some $40 billion on Olympics venues and improvements to Beijing’s infrastructure.
Then in late July, China started shutting down production and transport to reduce smog before the Olympic athletes, and the world, came to visit. China has shut down many factories and energy plants, or limited their operating time during July and August. Beijing residents must also adhere to a schedule of alternate driving days to reduce vehicle emissions.
In June and July, many commodity markets were marching to record highs. We saw crude oil peak above $140 a barrel. Since then, these markets have been correcting. Coincidentally, it’s come at the same time China has been shutting down in preparation for the Olympics. These corrections are likely to move a little further. We may get to $11 in soybeans, $111 in crude oil. But when the Olympics are over, when China turns its factories back on, the smog returns, and people return to work, I think there may be a good commodity buying opportunities ahead.
I am basically saying the commodity bull market is not over. I don’t want to catch a falling knife, and this correction is likely to continue for a while longer. I do think China as a global player isn’t going to go away though. Its citizens aren’t going to go back to riding bicycles. Perhaps China is a little tapped out of cash for the prom. But she isn’t going to stop spending completely. Demand for food and fuel won’t disappear. Let’s take a look at a few specific markets, and where I see prices headed this month and beyond.
Crude Oil
Crude oil has been a playmaker for many markets. Some analysts are saying crude oil could fall to $111, or even $100. Goldman Sachs came out after the market started pulling back from its record high in late July with the prediction that crude oil will return to $145 by year-end. I have to agree that crude oil is more likely to rebound than pull back much further from here. I don’t see crude going to $100.
If it’s true that the high prices have put a big crimp in demand, and that’s causing commodity prices to drop as we speak, it should be the case that demand will ramp up again after prices fall. If crude oil does drop to $100, will people stop worrying? Will demand come back? In my opinion, it could, and we could be right back up at the highs. The market needs to get back to $130 or so to revive the bullish trend, so watch that level on your charts. I do believe the market won’t see as much volatility on another leg up though. It will be more methodical. It might take twice as long to get to new highs as it did the first time around. Perhaps too much money had poured into commodities, too quickly.
Dollar and the Fed
Last month, I had recommended buying dips in the dollar. Now, the dollar is in a major consolidation area. The dollar has had basically five months consolidating at the bottom of a downtrend line. I think we are closer to a bottom than not, but I’ve been saying that for several months and we aren’t there yet. I had thought the dollar was going to break out, and I still think it will eventually. The September Dollar Index contract needs to close above 75 to confirm a breakout. We should see that once the Federal Reserve starts tightening interest rates.
The Fed decided to leave interest rates steady at 2 percent at the August 5, 2008 policy meeting, certainly not a surprise. The Fed has reduced its key short-term interest rate (known as the Fed funds rate) by 3.25 percentage points since mid-September 2007.
But at the August meeting, it did change its language slightly. Six weeks ago, the Fed said inflation was a bigger risk than a downturn. Back then, it was looking at different prices, when crude oil was surging to a record above $140, corn was above $7 per bu., and other commodities were at or near records as well. Since then, we had all kinds of problems in the financial sector, and continued weakness in the economy. So the Fed on August 5 assessed the problems of the economic slowdown and rising inflation as almost equal.
“Although downside risks to growth remain, the upside risks to inflation are also of significant concern,” the Fed said. It also dropped its earlier language that inflation risks have increased, as the market did some work for the Fed with price retreats since July.
The Fed also said it is watching employment. The unemployment rate ticked up to a four-year high of 5.7 percent in July—we’ve clearly lost jobs. My interpretation is that the Fed said it basically didn’t need to focus on inflation right now because the economy is slowing and the commodity markets have done the work for it on the inflation front by backing off. I personally think inflation is out of control, and the Fed should jump on it sooner rather than later.
Keep in mind also, the Eurozone economy is feeling weakness as we have here, but the European Central Bank has been focused strongly on inflation, and it has been in tightening mode while our Fed has been easing. If the ECB holds its key short-term interest rate steady at 4.25 percent amid concern about economic slowing, or even hints at lowering rates, the U.S. dollar should gain a more stream.
Keep your eye on the Dollar Index chart. If the September contract closes above 75, that will be bearish for commodities. Looking even further out, six months from today, we’ll know who the president of the United States will be. We’ll know if the banking system has collapsed, or improved. We’ll have the housing market recession or depression running on nearly two years by then. And we should know better by the first quarter whether the worst is behind us. At that point, I see the Fed raising rates, and the Dollar Index futures could be at 86. I would still buy dips, but I don’t want to take too much heat if the dollar can’t manage a breakout in coming months.
S&P 500
The stock market had been moving up nicely until subprime issues hit the fan in summer of 2007; then things really soured for equity investors. We seem to be getting by without a textbook recession, although it doesn’t feel that way to many of us, or by looking at a chart of the major stock averages. Whether I look at a daily, weekly or monthly chart, I see a bear market. In the September S&P futures, 1200 represents a correction of about 20 percent from its peak, a technical bear market. The market has come off its worst levels as commodities retreated, and I still believe the market will finish the year in better standing than where it is now. Even if the S&P tests 1200 in the fall, I see a nice rally coming into year end, and a single-digit loss to close out 2008. Watch 1290 in the September S&P 500 contract, and then 1340. A close above will have the bulls back in action.
Please feel free to call me to discuss these or other markets, and to incorporate specific trading strategies for your account size and risk tolerance. Good luck and good trading!
Jeff Friedman is a Senior Market Strategist with Lind Plus. He can be reached at 866-231-7811 or via email at jfriedman@lind-waldock.com. Join Jeff for his monthly webinar, Friedman’s Futures Forecast, by visiting Lind-Waldock’s events page. You can view an archived webinar of this forecast at www.lind-waldock.com/events, where Jeff covers even more markets.
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