A Rising Dollar and Cooling China Will Pop the Commodities Bubble

Investors who bet on a decline in the dollar in 2010 got taken to the cleaners. That doesn't mean that the carry trade -- using low-yielding currencies to buy higher-yielding ones -- is dead. It does mean investors will need to stop using the dollar as their source of cheap cash. And that shift has serious implications for those who have been betting against the dollar while buying commodities.

On Sunday, I predicted that 2011 would be the year the commodities bubble bursts. If the dollar strengthens, the only way commodity prices can keep rising is if demand exceeds supply. But China is putting the brakes on its economy with higher interest rates -- crimping demand -- at the same time traders find themselves needing to pay off their debts, and buying dollars with which to unwind their commodities bets.

Bullish Cocktail for Stocks

The actual results of recent bets against the dollar are startling to the debased-fiat-currency crowd. Bloomberg reports that IntercontinentalExchange's U.S. Dollar Index has jumped 4.5% from its 12-month low on Nov. 4. as investors gave up on the carry trade -- which lost 2.5% in 2010 -- to buy into U.S. gains in manufacturing (a 0.4% rise in November industrial production) and retail sales (+5.5% over the holidays).

Add these good statistics to the record corporate profits and cash balances recorded in 2010, plus the $858 billion tax cut, and you have a bullish cocktail for U.S. stocks.

One reason for the dollar's strength is the U.S.'s relatively robust economy compared to the eurozone, where third-quarter GDP gained a minuscule 0.4%. The eurozone's industrial production fell 0.9% in September, according to Futuresmag. Since many eurozone governments are cutting back on spending, it's likely that growth in the region will slow down even further, while debt concerns could intensify as the slower growth leads to more cutting, lower tax revenues and bigger deficits.

China Scrambles to Control Inflation

Since most commodities are traded in dollars, even the rising commodity prices -- many of which, as I posted on DailyFinance, peaked in October -- have been losing ground when measured against the strengthening dollar. But to understand commodities prices, it really helps to know what's going on in China. After all, as the world's second-largest economy -- and with a growth rate of 10%, its fastest-expanding one -- China's demand for commodities is likely to be the factor that determines prices.

But Chinese inflation is getting out of control. As Reuters reported, its 28-month-high inflation rate of 5.1% and record home prices "have sown public discontent, a concern for the government." And it is hard to overestimate how afraid the Chinese government is of the intensity of public protests that could ensue if the economy there gets further out of balance. Already, the median house price -- which rose 7.7% in 2010 -- is 111 times the median income, and food prices are rising at an 11.7% annual rate.

China is trying to control inflation by raising interest rates and forcing banks to boost reserves. The People's Bank of China increased its one-year lending and deposit rates by 25 basis points (100 bp = 1%) on Christmas Day in its second such move since mid-October, according to Bloomberg. That lending rate rose to 5.81% and is likely to end 2011 at 6.56%.

A Debt-Fueled Balloon

China is also trying to cut back on lending by raising bank reserve requirements above the current 18.5% mandate after 2010 lending exceeded the government's $1.1 trillion lending cap. Combining the increases in interest rates with the greater reserves requirements should slow down the growth of China's money supply, which has skyrocketed -- M2 climbed 55% from 2008 to 2010 as yuan-denominated loans surged 60%.

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In short, commodity prices have ascended in a debt-fueled balloon. Traders who borrowed money to bet against the dollar and buy commodities are being forced to pay back their trading debts by closing out their positions. Simply put, traders are buying dollars to cover their short bets, selling commodities to raise cash and using the proceeds to try pay off their loans. This forced selling should cause commodity prices to plunge while the dollar rallies.

It looks like America's fiat currency will start to zip ahead, while holders of commodities like gold will watch prices fall at a similar pace.