Which Came First?

Crude oil dropped $6.60 today to $108.86, an event which most of the media attributed to the relatively minor damage to Gulf coast energy facilities. There is more to this picture, though.

First, Gustav was no surprise to anyone. Oil companies had several days to batten down the hatches, during which time oil prices rose to account for the risk of lost production. If there was no damage, then the logical thing would be for prices to return to where they were before Gustav became a threat. In fact, crude oil ended today well below that point. This suggests that other forces are at work.

Was it coincidental that gold also fell hard today? No. In fact, the moves in both oil and gold were closely related to a rally in the dollar vs. other currencies. The dollar is bouncing back strongly from months of relative weakness. In the month of August, gold fell 9.5%, crude oil fell 6.9%, and the U.S. Dollar Index rose 5.7% – its biggest month in more than 15 years. Meanwhile, the Euro, the British Pound, the Japanese Yen, and the Australian Dollar all lost ground against the greenback. For this you can thank the Federal Reserve, which has kept real interest rates at historically low levels for far longer than anyone thought possible, or advisable.

A strong dollar means that Americans pay less, in real terms, for imported goods, chief among which is crude oil. This is sort of a chicken-and-egg quandary: did oil fall because the dollar strengthened, or did the dollar strengthen because oil fell? It’s hard to say. Nonetheless, the economic trends are growing clearer. The markets appear to have concluded that within the ongoing global slowdown, the rest of the developed world will lag the U.S. That is not to say the U.S. will soon return to its glory days as an industrial powerhouse; it just means that in a world of weakness, the U.S. is seen as the least weak player.

That being the case, there is reason to think that U.S. assets will continue to outperform those of other nations. Keep in mind, however, that “outperform” can mean “not lose as much as.” Falling energy prices are a sign of weakness, not strength, because it means the economy is still slowing down. There are plenty of reasons to be skeptical of even a mild recovery. The fact that this morning’s strong equity rally could not be sustained is troubling. For now, discretion is the better part of valor.