The rallies in gold, crude oil, and US Treasury notes and bonds are done! These investments represent the greatest risks in the markets today. I’ll leave US Treasuries for a later post.

While both crude oil and gold prices are easily subject to headline risk with the saber rattling of Iran and threats of closing the straits of Hormuz, investors should be viewing additional gains as opportunities to get out fast and look to redeploy elsewhere.

Fed’s policy did not cause gold price rise.

The Fed has intentionally erred on the side of accommodation since 2008 given the substantial dislocations from the financial crisis. I have little criticism of Bernanke policies as the loss of wealth from the crisis so overwhelms his easing policy. Bernanke literally wrote the book on the Great Depression. As he has stated in the past, monetary policy has tools to address unwanted inflation, but these tools become woefully inadequate when faced with severe deflation. Our economy has been most susceptible to deflation since the depths of the financial panic.

Indeed, it has been Bernanke’s policy of continued accommodation that has done the most to prevent a far worse condition as a result of the financial crisis in spite of those who point to the effects of the “stimulus” programs or of Rep. Ron Paul’s protestations.

It was a combination of rising commodity prices, esp. crude oil, and emerging economies’ growth

Crude oil prices reached a high in the summer of 2008, just before the full brunt of the financial crisis developed with the failure of Lehman Brothers and bailout of AIG. Arguably high oil and gas prices compounded the severity of the recession if not hasten its arrival (regardless that the recession was proclaimed to have started in December 2007). Likewise, gold prices realized a 10-year rise on the back of rising oil prices and the torrid growth of the emerging market economies, in particular China and India.

The basic inputs to production, raw materials, tradable commodities and crude oil all rose in response to unprecedented demand and tight supply as capacity had been reduced following years of slack demand. As these commodities are traded in dollars, the increases in prices and volume led to massive dollar surpluses in producer countries and emerging industrial export-led economies. The dollars earned had to be put work.

In the past, most owners of excess dollars were content to buy more dollar denominated investments, US Treasuries securities, US equities, US real estate, and so on. The recycling of petro dollars and export dollars has been and continues to result in favorable terms of trade for the US. We import tangible goods, crude oil, cars, watches, etc., and in return give paper to the exporting countries. They then take that paper (US dollars) and invest in more paper (US Treasuries, US Stocks, etc.) in the US.

Need to diversify out of dollars

However, soon after the 2000 stock drop and subsequent recession, owners of dollars decided that the sheer size of their holdings warranted diversification away from sole reliance on US dollar denominated investments. Every other market is dwarfed by the size of the US dollar market; therefore, even a small increase in allocations causes large movements in prices in those alternative markets.

Gold was the first alternative holders of excess dollars targeted. Tracking gold prices to crude oil reflects a near parallel price development. Critics of Fed monetary policy contend that it was the decrease in the value of the dollar from too accommodative policy that caused the massive increases in commodity prices. But studying the price charts reveals a different picture. From 2002 to mid-2008, oil prices went from $20 per barrel to over $140 per barrel, an increase of over 7 times the 2002 prices. Likewise, gold went from $300 per oz to over $1000 per oz over that same period for an increase of nearly 3.5 times the initial prices. The dollar over this same period, however, decreased in value only 30%. Furthermore, the Fed was tightening monetary policy from June 2004 to September 2007, the bulk of time during the commodity price surge.

It would have been a massive undertaking if the Fed had attempted to somehow sterilize the increased dollar liquidity caused by the increases in crude and gold prices. Such a move would have likely  thrown the US economy into an even more severe recession and likely depression earlier than the summer of 2008. The dollar’s reserve status in effect provided substantial flexibility, cushioning both the domestic US market and the international system from the stress caused by the growth in demand for commodities throughout the world. If the critics were to be believed, the Fed’s aggressive accommodative stance should have caused the dollar to continue to fall in value since the beginning of the financial crisis. Yet the price action of commodities and the dollar index is inconclusive at best. Crude oil prices have recovered part of the losses from the summer of 2008, and the dollar index has stabilized since 2008. Only gold has continued to advance.

Slower growth will moderate prices, sans the end of the world, of course

The factors that played into the strength of oil and gold for most of the first decade of this century are reversing in this second decade. Today, world growth prospects are more tepid and a decade of higher prices in commodities has led to greater output capacity.  Iraqi oil production potential–when realized over the next five to eight years–will challenge Saudi Arabia as the swing producer in OPEC.

Having already stated that $70–80 a barrel of oil is within their comfort zone, the major OPEC producers and exporters are more aware of the potential destabilizing effect higher crude oil prices have on the economic growth prospects of the largest oil consumers.

Yes, a major geopolitical event probably would generate a temporary spike in prices. However, investors that have not already done so should take the increase in prices as an opportunity to get out.

originally posted March 14, 2012