Analysis from AdvisorAnalyst.com

Does The Dollar Rally Threaten the Loonie and Commodities?

Since late November the U.S. dollar has rallied strongly against the yen and euro, and also the loonie. What's unusual is that the Canadian dollar has not weakened proportionally against the dollar in the same fashion as the euro or yen. And, commodities, have, in fact, hardened against the dollar during the last three weeks.

Ernest Kepper, former senior official of the International Finance Corporation (IFC) and Wall Street investment banker who now heads an Asian financial consultancy says, "The unwinding U.S. dollar carry trade is the most dynamic trend for 2010 where financial crises could erupt. Basically the U.S. dollar carry trade consisted of going short the U.S. dollar and long on very highly leveraged equities and commodities."

He continues, adding, "This direction of change could be very significant as it could result in the U.S. dollar rising sharply against most currencies, especially the commodity-related ones with the drop in prices of equities and commodities."

The dollar index (DXY) shows the dollar rallying, against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona basket.

The USD/JPY cross shows the dollar rallying against the yen…deflationary pressure means the Bank of Japan has had to resort to quantitative easing, offering 3 month paper at 0.1% – It looks as though the yen is set to replace the dollar as primary carry trade funding currency.

The EUR/USD cross shows the dollar rallying against the euro – or the euro selling off against the dollar…

The AUD/USD cross shows the U.S. dollar rallying against the Aussie too&hellp;

The dollar is also rallying against the Russian ruble and the Brazilian real too.

But, what's interesting is that the dollar's rally has, to date, been comparatively weaker against the loonie, and the CRB Index.

Are foreigners buying the Canadian dollars/bonds as an alternative to U.S. treasuries? It appears that in overnight European trading sessions the loonie has been holding its own against the greenback. It weakened, initially, at the outset of the dollar rally, then gained support against the greenback.

In the latest issue of Basic Points, Donald Coxe, Coxe Advisors, writes, "Canada has been starring in some G-7 rankings published by international journals:

#1 ranked central bank
#1 ranked banking system
#1 ranked Minister of Finance

"These rankings suggest that the Canadian financial system is exemplary – at least by G-7 standards and in comparison with the US – which is, for most foreign investors, the only really crucial comparison."

As well as covering short positions in the dollar, are investors taking long positions in the Loonie? Its probably too early to tell, but it would not be a big surprise if foreign investors warmed up the loonie, a la Donald Coxe.

And what of commodities? Oddly, the CRB index has experienced a modest rise along with the rally in the dollar, and then gone range-bound. Mainstream press calls this a vote of optimism in a global recovery. Or is that a new carry trade on an unsustainably high yen has ignited the market's afterburners, as there are now overlapping carry trades? As the dollar funded carry trade recedes and the dollar strengthens, is it possible for commodities to maintain their current altitude and move higher off the yen carry trade?

Hosein Askari, professor of international business and international affairs at George Washington University, asks the question, "Who is paying for the beer?"

"The Fed has been printing money and fanning loans at near zero interest rates. Speculators and borrowers have been enjoying gains and wealth. Japan's central bank has been doing the same thing since financial crisis broke out in 1992. The question is: who is paying for free gains by speculators (and bankers) and sub-prime borrowers? Let's see if we have an answer… In spite of the impotence of money policy and the inability of banks to continue fanning loans to sub-prime markets with a certainty of loss, central banks have chosen to intensify empty money creation, reduce interest rates to near zero, and redistribute wealth in favour of speculators.

So, is the dollar rally a threat to the loonie and commodities? At the very least, it's disruptive and we'll see the return of volatility, risk aversion. At best, the resumption of the yen carry-trade may provide support to commodities and equities markets. I agree with Donald Coxe's thesis that Canada bonds will be favoured by foreigners who believe they are the best in the G7 and that means a stronger loonie. And by the way, a stronger greenback and loonie are deflationary.