by Houghton and Atkeson 05/09/08
Editor's note: While Sam Collins is on vacation through May 15, OptionsZone.com contributors and professional traders Andrew Houghton and Nick Atkeson are taking over the Daily Market Outlook as guest columnists.
We addressed the U.S. dollar/commodity trade recently, as it has flip-flopped over the last 10 trading days. It's a topic on many traders' minds these days, and it's in the headlines again.
Crude oil futures, although traded globally, are priced in U.S. dollars per barrel. As the value of the dollar falls versus other currencies, the price per barrel of oil rises regardless of any other demand/supply forces at work.
Additionally, crude and other physical commodities such as gold are often used as a hedge against inflation, as they hold their value as prices increase. The combination of increased inflation expectations and a lower exchange rate for the dollar has prompted investors to sell dollars and buy commodities.
Yesterday's Financial Times included a piece alluding to collaboration between the United States and the European Union to strengthen the dollar. The article discusses both entities desire to see a stronger "buck" but also includes their thinking that "fundamentals and central bank policies are turning in the direction of relative dollar strength."
The dollar, represented here by the DXY futures contract, closed at 73.477 last night -- up a little over 3% since its low close of 71.329 on April 22. It would appear from this that the dollar is moving in the desired direction.
ENERGY NAMES POWERING OVER CRUDE
The move in crude oil futures, however, has not abated as the current-month crude contract closed at another high yesterday and did not seem to be moving anywhere but higher in after-market trading.
We remain long a number of names in the energy sector, primarily in the exploration, extraction and services businesses of that industry. The sharp move down in crude oil after May 1 caused us to cut some the weaker energy names from the portfolio, including Hess Corp. (HES), Apache Corp. (APA), Diamond Offshore Drilling (DO) and Halliburton (HAL).
Since then, however, other names Suncor Energy (SU), TECO Energy (TE), Oneok (OKE) and Enterprise Products Partners (EPD) have replaced those as the move in crude has resumed.
CURRENCY VIGILANTES ON DOLLAR DUTY
In 2004 Richard Russell, author of the Dow Theory Letters, wrote about the "bond vigilantes." These were participants in the U.S. government bond market who would sell long-dated Treasury securities at any hint of monetary policy that was deemed to be inflationary.
This came at a time when then Fed Chairman Alan Greenspan had reduced the Fed Funds rate to 1%, creating the debt bubble that exploded last summer and is still being cleaned up.
Inflation is once again becoming a concern as our current Fed Chairman Ben Bernanke has lowered rates to 2% in an attempt to get the economy moving again. The bond vigilantes of yore have now been replaced with "currency vigilantes." This group is actually hoping for inflation in the U.S. as the higher rates will make the dollar a currency to buy instead of sell.
HOW CAN YOU 'INFLATE' YOUR PORTFOLIO?
Much has been discussed with regard to the effect Greenspan's policies had in creating the real estate bubble. Ben Bernanke, known for his predilection for easy money policy, would appear to be the perfect person to feed the flames of inflation and the next, as-yet-unknown bubble. If that is the case, the time for the bond vigilantes to ride again could soon be approaching.
With the Fed Funds rate at 2%, inflationary pressures will steadily become more intense -- i.e., too much money chasing too few goods. Additionally, with the emergence of China, India and other developing countries, we add too many people chasing too few goods to the inflationary pressures of cheap money.
As inflationary pressures grow, the demand for stocks representing hard assets will also increase. In the energy sector, this will include those companies that find and extract oil along with the firms that service those companies, such as Halliburton (HAL), Baker Hughes (BHI) and Schlumberger (SLB).
Companies such as the utilities that use the refined products -- AES Corp. (AES), Exelon Corp. (EXC), and Pepco Holdings (POM), for example -- will be hurt by high raw-material prices and should be avoided.
Andrew Houghton and Nick Atkeson work together to identify unusual options trading activity on the "big money" (i.e., institutional) level and regularly contribute their findings to OptionsZone.com.
For a timely look at big-money options trades taking place under the radar and independent of the headlines, visit Andrew and Nick's full archive of Unusual Options Trading Activity by clicking here now!
