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Dollar, commodities’ trades under threat

* Investors pumped money into emerging market assets and commodities as dollar fell in the week ending Nov 18

LONDON: Trades betting on higher commodities and equities and a weak dollar may see a quick and sharp reversal if a renewed rise in oil prices fans inflation concerns and prompts early exit from ultra-easy monetary policy.

These trades exploiting high correlation between the dollar, dollar-priced commodity prices and related shares have been a key feature of the year-end rally as investors grow convinced that policymakers in the developed world would keep interest rates near zero.

The dollar has hit a 15-month low against a basket of major currencies, fuelling gains in dollar-priced commodities. Gold hit an all-time high above $1,152 an ounce this week, while global commodities benchmark Reuters-Jefferies CRB index hit a 3-1/2 week peak.

The only piece missing in this correlation puzzle is crude oil, which has been stuck in range just below $80 a barrel and is not making new 2009 highs. Relatively tame oil prices have helped keep inflation concerns in check, allowing policymakers to keep flooding the system with huge liquidity and underpin the economic recovery. Once oil prices take off however, central banks around the world might withdraw this support more quickly than investors think, which would destabilise the correlation trades.

“There is loads of cash on the sidelines and there’s been a constant trickle into the market and keeping the tide going,” said Paul Kim, director of portfolio management at FundQuest. “They will keep the foot on for a little bit more but that’s until when inflation risks come in. That’s very worrying for central banks. There is a definite danger.”

Next week’s release of the minutes of the Fed’s November meeting would give more clues to their thinking. At their last meeting on Nov 3-4 Federal Reserve policymakers reiterated a pledge to keep interest rates extraordinarily low for an extended period. Fed officials have been also stressing that inflation is not an immediate threat as a weak economic recovery and a grim outlook for jobs keep price pressures in check.

Pumping in: Investors pumped money into emerging market assets and commodities as the dollar fell in the week ending Nov 18. Emerging market equity funds attracted just over $2.7 trillion during the week, pushing the total inflows this year to a record $56.8 billion after an outflow of $40 billion in 2008.

Commodity funds, which currently account for nearly three-quarters of the inflows into all sector fund groups so far this year, took a record $1.34 billion for the week with year-to-date inflows climbing above $13 billion.

Reflecting the lack of a strong rally in oil, energy sector funds posted a modest outflow for the week. The BofA Merrill Lynch monthly fund managers survey showed the net overweight position on commodities stood at a record high of 25 percent this month, while their net equity overweight position also increased slightly from October.

And inflows into equities and commodities are driven by investors taking money out of low-yielding money market funds. US money market funds saw an outflow of $50.41 billion this month alone, pushing their assets down to $3.29 trillion in the week ended Nov 17, according to the Money Fund Report.

“Today, with zero, or near zero interest rate policies, we see a repeat of rapid carry trades and leveraged capital flows that are once again creating asset bubbles in the emerging markets,” Donald Tsang, head of the Hong Kong Monetary Authority said in a speech earlier this week.

Reversal risk: The dollar index has lost nearly seven percent this year, with near zero dollar rates driving the quest for high-yield assets outside the United States. “As the dollar is the currency of international settlements, its use in carry trades will have a greater effect on dollar denominated assets than the yen did when it was used in carry trades,” BNP Paribas said in a note to clients.

But the risk of a sharp reversal looms. Triggers could well be signs of tightening in countries other than the United States but emerging markets, where they are experiencing robust growth.

“Chinese tightening, more rate hikes in the ‘fast movers’ and less liquidity could, when combined with the ‘soft patch’ we see coming, add up to a more nervous period for risk markets,” BNP Paribas said. “Thus, we see the dollar as likely to have something of a rally next year.” reuters

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