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Friday, May 26, 2006

A Dollar Bubble?

"Soaring Commodity Prices Point Toward Dollar Devaluation"

A very troubling report:

The astonishing rally of commodity prices during the past 12 months has taken most analysts, economists and investors by surprise. Rather than a dramatic change in the relationship between supply and demand for the underlying commodity, surging commodity prices have been driven by the devaluation of the preeminent marker of international commodity values -- the U.S. dollar. In the months ahead, the dollar's devaluation will increasingly register against other major currencies. Rapidly deteriorating U.S. economic fundamentals, questionable policy at the Federal Reserve, increasing political instability and extreme global geopolitical instability may trigger significant foreign capital flight from the United States.

Brief History of Commodity Prices

In late 2005, the Commodity Research Bureau's broad commodity price index, known as the C.R.B. Index, quietly surpassed record high levels set in the early 1980s. By the third week of May 2006, the C.R.B. Index gained another 12 percent. Behind this year's rise in the C.R.B. Index have been unprecedented price rallies of individual commodities. In the first five months of 2006, crude oil prices have increased by a mere 14 percent followed by gains in corn and wheat of about 10 percent. Price gains for other commodities have far outpaced the gains of oil and grains.

Zinc prices have doubled in the past five months, copper prices are up 80 percent, silver has risen by 60 percent and palladium, tin, gold, aluminum and platinum have gained 50 percent, 40 percent, 39 percent, 36 percent and 35 percent, respectively. Prices for other commodities including lead, iron and scrap iron have followed a similar path this year. While these commodities have vastly varied uses from industrial to food production, they all have one common feature -- they are denominated and traded internationally in U.S. dollars.

It is a dubious notion that global economic growth has suddenly reached a point where worldwide demand has overwhelmingly and simultaneously outstripped worldwide supply of all these commodities. In 2005, real global economic growth slowed to about 3.2 percent from nearly four percent in 2004. Slower global economic growth was led by slower real economic growth in the United States, which decelerated to 3.5 percent in 2005 from 4.2 percent in 2004. Global demand for commodities was actually declining, as prices for these commodities began to gallop higher in 2005.

Falling Commodity Value of the Dollar

While U.S. and global real economic growth accelerated in the first quarter of 2006, this acceleration was hardly sufficient to be behind the further rise of commodity prices in the first five months of this year. Rather than demand pushing the value of commodities higher in the past 18 months, it has been the dollar's devaluation against commodities that has pushed commodity prices to record highs. In other words, it is not zinc, copper and silver prices that are gaining; it is the value of the dollar that is declining against these commodities.

The devaluation of the dollar against the world's major commodities is being driven by the exceptional growth in the world's supply of dollars during the past two years. Growth in the world's supply of dollars has come from two primary sources: rising international oil prices and the very large and growing U.S. trade deficit.

Rising international oil prices during the past two years have dramatically increased global demand for and supply of dollars, which are used to buy crude oil. These dollars end up in the hands of the world's crude oil producers, who have invested some of this windfall in U.S. Treasury, agency and corporate bonds. Similarly, the U.S. trade deficit has lavished dollars on many countries that produce exports bound for the United States during the past two years. Again, most of this windfall has been invested in U.S. Treasury, agency and corporate bonds.

To get an idea of the magnitude of growth in the world's supply of dollars during the past two years, one must calculate the dollar value of rising crude oil prices and add to this the size of the U.S. trade deficit. In 2004, global demand for crude oil grew by about four percent. Higher oil prices, which advanced by 34 percent, and demand for oil combined to increase the world's dollar supply by about $330 billion. In 2005, international crude oil prices gained another 35 percent and global demand for oil grew by only 1.6 percent. Nonetheless, the world's supply of dollars increased by a further $460 billion.

The U.S. trade deficit was $666 billion in 2004 and $782 billion in 2005. Thus, in 2004 the world's supply of dollars grew by over $1 trillion, which was overshadowed in 2005 when the supply of dollars grew by a further $1.2 trillion. Adjusting these figures downward for double counting the portion of the U.S. trade deficit linked to crude oil imports still leaves the average annual growth of the world's supply of dollars in excess of $1 trillion per year in 2004 and 2005. According to data from the U.S. Treasury, foreigners invested about $900 billion in U.S. securities in both 2004 and 2005. At the end of 2005, foreigners held about $4 trillion worth of U.S. debt securities and about $2 trillion worth of U.S. equities.

Of course, the world's supply of dollars has also been pushed higher during the past two years by rising prices of other dollar-denominated commodities such as zinc, copper silver, palladium, and tin, among others. Although most of the increase in the world's supply of dollars since 2004 has been reabsorbed into U.S. bonds and equities, as much as $600 billion remains outside of U.S. asset markets. Some of this money has undoubtedly found its way into the asset markets of other countries. Most of it, however, has been parked in alternative investments such as commodities. Rather than a bubble in commodity prices, as at least one prominent economist has asserted, recent commodity price action is indicative of a growing bubble in the world's supply of dollars.

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