FXIBonline Third Quarter Report 2010

Foreign Exchange Market
In the third quarter we saw the dollar sell off across the board, due to the Federal Reserve board being  bearish on the US economy and considering more Quantitative Easing towards the end of the year if need be. We do not foresee the Fed needing to institute more QE because we believe this summer was a soft patch in the economic recovery and will strengthen going into the fourth quarter. The US dollar has recently declined to a six month low against the Euro, the stronger Euro is already negatively impacting smaller European counties such as Greece and Ireland that actually need the Euro to depreciate to remain competitive and finance their debt.  It is also interesting to note that US dollar shorts have hit a high not seen since mid-2008. In mid-2008, the EUR/USD was trading at 1.60 and eventually sold off to 1.23 as traders and asset managers reduced their dollar short positions.  A benefit of the weaker dollar  is it will help our exports creating a positive impact on our economic recovery. The weaker dollar will act as a mini “stimulus” and should help the manufacturing sector which has been leading the recovery. A recent report by Bloomberg utilizing a purchasing power basis estimated that the Australian dollar was overvalued by as much as 67%. Not only does a strong Australian Dollar have a negative impact on the Australian economy, but it means that at some point Australia will need to take steps to curb the strength of their currency to prevent deflation.

Commodities
This past quarter we saw commodities prices at record highs.  Wheat hit 815.50 a bushel and currently is trading around 700, up almost 67 percent from its low in early June of 474.  Corn hit a high of 536 from its yearly low of around 356 also established  in June. This price action was prevalent throughout the commodity sector during the third quarter, including gold and silver which are enjoying all time highs.  What is causing this?  Russia was an unfortunate recipient of poor weather this year resulting in damaged crops with the consequence being a cap on their commodities exports. Australia has also struggled with production given their weather patterns however, the U.S. has managed to remain fairly consistent because of our technological advances such as irrigation and types of seed. One exception to this quarter’s commodity rally is oil. Oil has not enjoyed this surge in pricing primarily due to the underlying economic factors surround global expansion. Not even the massive oil leak in the Gulf of Mexico was able to  push prices significantly higher.  These kind of price increases remain unsustainable in the short term given that the US still has a 9.5% unemployment rate.  Many market participants including us at FXIB compare this current situation to that of oil in the summer of 2007.  When prices of commodities rise this high this fast the shock to the global system hits in waves, these waves cause mini bubbles in prices not only for food producers and consumers but in how banks structure loans and lines of credit based on overcapitalized hard assets.   As a result of these bubbles when markets do re-align themselves, (and they will as we saw with oil) you are left with over priced bonds, loans and market valuations that will not be able to be sustained at these historical price levels.  What does this mean for the average investor?  Be careful buying commodities or commodity tied investments at these prices. Based on our research, gold is not an effective hedge against inflation, but is  rather more effective as a  hedge against the debasing of the US dollar. If the US Federal Reserve does start more Quantitative Easing, commodities could rally further however, we do not believe the Fed will need to do another round of Quantitative Easing.

Fourth Quarter Outlook
Given this backdrop, we expect commodities and commodity related investments to sell off in the fourth quarter and possibly into the first quarter of next year. We expect the US dollar to recovery some if not all of its recent losses and will keep a close eye on the US Federal Reserve statements as to any clues or direction they may take in regards to Quantitative Easing. We are also keeping an eye on the Chinese Currency Bill that just recently passed the US House of Representatives. The bill labels China as a currency manipulator and gives US companies the ability to levy charges on Chinese imports. If this bill is signed into law, we should see AUD/USD sell off as a proxy for the USD/CNY exchange rate. This bill is the toughest response by the US in regards to China’s polices.  A currency war is already raging behind the scenes in which each country is trying to devalue their currency to stimulate economic growth. (what we call a race to the bottom).  We do expect volatility to remain about the same, and we will continue to keep on eye on the leading economic indicators for the US economy.