Cezary Salad

On Tuesday night the Penn Club of New York held its 10th annual Hedge Fund Panel, sponsored by the Club’s Hedge Fund Intra Club, during which six hedge fund managers shared their views on everything from where they see distressed investment opportunities to whether speculation is driving up oil prices (emphatic no). I attended the panel to benefit from their perspective and thought I would share some of the take-aways so that others may benefit as well.

The panelists included Arif Joshi, portfolio manager at Halbis Capital Management (the asset management arm of HSBC), Jed Hart, senior managing director of Centerbridge, John Khoury, portfolio manager at Wesley Capital, Aaron Cowen, managing director for Karsch Capital Management, Jerry Cudzil, managing director at DAC funds, and Leslee Cowen, managing director of the Drawbridge Special Opportunities Fund at Fortress Investment Group.

Obviously, with the economy in a downturn, opportunities to invest in distressed assets were a big focus of the discussion. Asked where they see the opportunities in their respective asset classes, the panelists seemed in agreement that the best (or worst, depending on how you look at it) is yet to come since corporate distress is at the lagging - not the leading end - of defaults. However, the panelists noted that this cycle is different from anything we’ve seen before in several respects. For one, Mr. Hart - who helps manage a credit opportunities fund at Centerbridge - mentioned that “it’s just much bigger” since there’s been about $2 trillion of high yield debt securitized in the last few years. So if corporate default rates, which he said are still incredibly low, start to tick-up to a rate even half the default rate of last credit downturn in 2002 (about 12-15%), there will be “plenty of dollars of default securities to look at and invest in,” with consumer cyclicals leading the charge.

Ms Cowen, whose group within the Drawbridge fund focuses on distressed debt and special situations investing, seconded those thoughts but added that this cycle is also unusual in that defaults are being led by the mortgage markets, not corporate defaults - as was the case with the last cycle. One reason for this, of course, is the downturn in the mortgage markets following the subprime meltdown. But Ms Cowen added that corporations have “a lot of extra cushion” this time around since many of them refinanced their debt in 2005-2007, before the fallout from the credit crunch materialized, and thus have some leeway in terms of liquidity and covenants on their debt. So give it another quarter or two before we start to see some real activity in corporate defaults.

(Meanwhile, of course, the smart money is already well-positioned to take advantage of this trend: earlier this year, the Blackstone Group paid $930 million for GSO Capital Partners - a fund that is now raising money to invest in distressed opportunities).

Taxes were another hot topic during the panel since it looks increasingly likely that Congress will pass the carried interest tax this year, which would tax carried interest - the share of a fund’s profits that goes to the partners - at the rate of ordinary income instead of capital gains. This would effectively mean that that hedge funds and private equity partnerships would have to go from paying 15% to 40% of their profits in tax. The panelists seemed resigned to this development. “It was good while it lasted. If it’s going to end, it’s going to end,” Mr. Hart, commented, adding that he sees this as part of a normalization of tax codes taking place in the U.S. since “there’s no reason why a doctor should be taxed more heavily than an investment analyst.” However, Mr. Hart mentioned that he doesn’t foresee hedge funds shifting operations abroad in response to this - which makes sense since MPs in Great Britain are also spoiling to tax carried interest at a higher rate.

Besides tax strategy, though, operational efficiency and cheaper labor provide additional incentives to shift operations abroad - notably to places like India. Asked whether hedge funds would follow investment banks in taking advantage of this trend, the panelists shared mixed opinions. Mr. Khoury of Wesley Capital, whose hedge fund focuses on real estate securities, noted that “hedge funds get paid for research at the end of the day” and that includes going out to meet management and look at assets. “I just can’t see what part of our investment process you could take outside of the office or outside of the team and outsource it in a way that adds value to it,” he concluded. However, Mr. Cudzil noted that his hedge fund does employ a service that gives it access to six analysts based in India who help it with routine analytical work that has to be done on a daily basis, such as dollar price tests, earnings tests and updating models for annual reports. “We have found it helpful,” he said. So it outsourcing may be less relevant for funds that invest in something tangible like real estate and more important for funds that analyze less tangible investments, like structured credit.

Two other areas that panelists were asked to comment on - the SEC’s restrictions on short selling and the impact of speculation on commodity prices - yielded unsurprising responses. The panelists viewed short selling as a healthy function of the capital markets. One of them opined that short sellers provide a service to investors who might otherwise be buying shares of companies at the wrong price and that restricting short-selling is un-American and akin to socialist restrictions on a free society. And when asked - by me, given my interest in this topic - to comment on whether speculators are driving commodity prices higher, Mr. Cudzil seemed to speak for the panel when said that he believed that global commodity markets are too big to manipulate. “Short-term manipulation in the markets driven by speculators will quickly be corrected,” he said, and supply and demand fundamentals will ultimately drive the markets.

Other trends the panel touched on would also not surprise those who follow the hedge fund world: the big funds will likely keep getting bigger, emerging markets provide some compelling valuations (esp. places like sub-Saharan Africa and South America) but also bigger risks, and it’s as important as ever for investors to do their homework and research their manager before they invest.

This is the last of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Last Thursday’s post focused on the role of dollar depreciation. Then, on Saturday I reflected on the tightening outlook for global supply and demand. Today’s post will examine the impact of commodity price speculators.

The third - and definitely the most controversial - long-term trend that has put upward pressure on oil prices is increasing commodity price speculation.

Under most circumstances, financial theory would dictate that the inflow of speculative capital can’t have an outsize effect on a market as large, open and actively traded as oil futures. That’s because such a market is bound to have a large variety of participants - technical traders, physical hedgers, fundamental investors, passive investors, mean reversion traders - all following various objectives and trading strategies that can’t really have a measurable impact on it.

However, this fails to hold true if there’s so many participants all following the same strategy that they do in fact move the market by creating an imbalance between the number of buyers and sellers, resulting in either a spike (via excessive buying) or a crash (via excessive selling).

And, by the looks of it, that’s precisely what’s going on in the oil futures market right now. Over the past five years, an influx of new investors have flooded the commodity markets with speculative capital, much of it following the same strategy - go long and hold - which helped to create a spike in oil prices.

Big money, big market

Let’s start with the numbers. In May, Michael Masters, manager of hedge fund Masters Capital Management, estimated that assets allocated to commodity index trading have risen twenty-fold from $13 billion at the end of 2003 to $260 billion as of March 2008. Fair disclosure: his hedge fund stood to lose a lot of money with rising oil prices, so he had an interest in arguing for greater regulation of the commodity markets. Moral hazards aside, though, in early July, CNNMoney.com reported that the International Energy Agency had came up with nearly identical figures: $15 billion in 2003, growing to $260 billion by 2008.

Where did all this money come from? The inflow of speculative capital was enabled in large part by an innovation in the world of Exchange-Traded Funds (ETFs), which track indexes but can be traded like stocks. Since 2005, when Barclays Global Investors created the first broad-based commodity ETF, commodity ETFs dedicated to tracking the performance of futures commodity indexes like the Dow Jones AIG Commodity Index (DJAIG) or the Goldman Sachs Commodity Index (GSCI) have mushroomed. This empowered investors worldwide to participate in the commodities bull market like they never could before and naturally led to a huge influx of capital - and not just from hedge funds. In late 2006, for example, CalPERS - one of the largest U.S. public pension schemes - announced that it would earmark $500 million for a pilot commodities investment program. And CalPERS definitely wasn’t alone. By 2008, Masters estimated that investors bet nearly $1 billion per day on commodity indexes in the first 52 trading days of the year.

But it is important to view these numbers in context: there are trillions of dollars’ worth of commodities contracts traded every day (New York Times business columnist Joe Nocera puts the figure at $5 trillion). In this light, a couple hundred billion worth of speculators’ capital can only have a material impact if their positions are so concentrated on any one strategy that a large-scale retreat from or a run to that position reverberates through the market.

Crowded investment strategy

To see how this can happen, it’s important to first draw some distinctions. The Commodities Futures Trading Commission (CFTC), the regulatory body tasked with overseeing the commodity futures markets, distinguishes between two types of participants: commercial and non-commerical. Commercial participants are those who have a legitimate commercial reason to hedge their exposure to a given commodity - such as a grain farmer or an oil refinery - whereas non-commercial participants are those who participate in the market purely for financial gain (i.e. speculators). Both, however, act in the same global market and therefore answer to the same oil prices. Furthermore, there are two types of trading strategies of interest in examining non-commercial participants’ impact on the market: long and short. Long positions bet on rising prices and therefore their accumulation tends to put upward pressure on prices; short positions bet on falling prices (by borrowing shares, selling them high, repurchasing when low, returning them to the borrower and pocketing the difference) and therefore their accumulation tends to put downward pressure on rising prices.

Armed with this knowledge, let’s look at the trends. Last year, the same Congressional committee that Masters testified in front of tasked Edward Krapels, manager of the gas and power practice at consultancy Energy Security Analysis, Inc., to answer essentially the same question: what is the effect of index speculators on oil prices? To answer the question, Krapels examined the difference between non-commercial speculators’ long and short positions on West Texas Intermediate (WTI) crude oil from 1986-2007. What he found was that, with some exception, between 1986 and 2002 non-commercial investors were net short on oil. Between 1992 and 2001, they oscillated between net long and net short interest. But between 2002 and 2007 - a period which saw WTI rise from $20 to $100 - the non-commercial investors were usually net long. For the sake of convenience, below I’ve reproduced the charts that Krapels uses to illustrate these trends (sorry for the bad resolution):

If anything, after Krapels’s testimony in December 2007 we can only guess that this trend continued to snowball. The public spotlight on the tight global supply and demand conditions as well as the plunging dollar gave non-commercial commodity investors few reasons to go short - an indication of how inter-connected these three trends really are. And again, the credit crunch stands out as the common element because in its wake, with the debt markets frozen and the equity markets in disarray, commodities indexes stood out as the only relatively safe place for skittish investors to park their vacant capital. The result? More capital chasing futures contracts using predominantly the same strategy: go long and hold.

Material impact on price

Now, keep in mind that futures prices are driven by expectations. As I argued in my last post, worries about fundamental supply and demand are already putting upward pressure on futures. But this effect is exacerbated by specualtors’ increasing net long interest in oil futures contracts because as more index speculators wishing to go long and hold crowd the market, the marginal futures contract becomes more expensive to purchase, which bids their prices even higher.

Here it is crucial to point out that commodity futures contracts expire every month, which forces their holders to either take the physical delivery of the commodity or to sell the contract. In practice, only about 5% of futures contracts ever result in physical delivery, and this figure isn’t any different in today’s market than in years past. So critics argue that non-commercial commodity investors cannot possibly be bidding up the price of oil since they are not removing a single drop of oil from the market (this is a point espoused by New York Times columnist Paul Krugman); they simply use calendar swaps to sell the contract to someone else before it expires and physical delivery is ultimately accepted by a commercial market participant. Thus, were non-commercial interests bidding up the price of oil, we would see huge pile-ups in oil inventories thanks to the likes of Goldman Sachs and JPMorgan, which is not the case.

But this line of reasoning misses the point. It is not the physical delivery of oil today that determines its price. Instead, it is the futures markets that are at the very front and center of how oil is priced since - as I explained in my last post - oil is priced over a futures benchmark.

Mixing water with oil

This distinction helps explain why comparisons to other commodities markets which are not as heavily traded as oil but are nonetheless surging in price - such as the global market for iron ore - are off the mark.

Yes - by all measures, prices for iron ore globally are booming thanks to growing demand from China. And because this is a market in which the only market-making activities are individual contracts between buyers and sellers, there is no room for speculative influences. Ergo: fundamental demand must be driving iron ore prices, not fundamentals.

Fair enough. But to point to this and to say it this is evidence that oil must also therefore be booming purely because of fundamental demand brushes over several crucial differences that don’t make this an apples-to-apples comparison:

• Oil pricing is benchmarked off of futures contracts. Iron ore pricing is based on spot contracts between individual market makers
• Oil has far more sophisticated market mechanisms that allow for greater price discovery (exchange-based trading, swaps, futures). Iron ore doesn’t
• No one market participant is large enough to significantly impact the price of oil. Conversely, the market for iron ore is dominated by big players who have significant control over price; when Brazilian miner Vale announced in February that it would sell iron ore to South Korean and Japanese steelmakers for 65% more than its 2007 prices, that deal effectively set the price benchmark for the whole industry
• The price of oil is growing by leaps and bounds. Iron ore is experiencing a more modest price escalation. Even a 65% year-over-year increase isn’t bad compared with the more-than-doubling of oil over the last year

Clearly, this well-intended comparison mixes water with oil.

Stormy outlook

Considering all of this, it is difficult to argue that speculators aren’t having any impact on the skyrocketing price of oil. Rather, the appropriate questions are: how much of an impact and how big relative to the other two trends. This is difficult to quantify, but estimates such as 50% of today’s oil price being caused by speculation - as offered by Masters during his testimony - don’t pass the smell test and only galvanize those who wish to keep speculators’ hands clean (in which case, rather than focusing their efforts on rebutting Masters’s testimony point-by-point, critics should try to deconstruct the much more balanced analysis offered by Krapels).

At the same time, though, it is important to remember that any price tag that we apply to speculation’s share of a barrel of oil would not be as high as it is without dollar depreciation and concerns about tight supply and demand since the three are very closely interconnected. As Krapels put it, “it would be naïve to expect any sustained causation between trading strategies and prices,” but “there are, nevertheless, several areas where causation should not be dismissed, all of them consistent with normal economic analysis,” among which he names:

1. Perfect storm episodes: there are likely to be periods of time when the condition of the physical energy market and trading strategies of financial market participants are in such good alignment as to produce “herding” and “bubbles” or their opposite, crashes
2. Variations on the market power syndrome: It is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects

By the looks of it, we are currently experiencing both situations: the mixing of these three trends has indeed created the perfect storm, and the resulting influx of long-and-hold speculators helped to grow it into the hurricane that it is today.

This is part two of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Thursday’s post focused on the role of dollar depreciation. Today’s post will focus on the tightening outlook for global supply and demand.

The outlook for diminishing supply combined with surging global demand for oil is probably the best-documented of the three long-term trends that are driving up oil prices - the other two being the depreciating dollar, which I wrote about on Thursday, and speculation, which I will write about in a future post. It is also the explanation most favored by everyone from the business press to regulators and talking heads on CNBC.

However, there is reason to believe that its impact on current oil prices is not as powerful as everyone believes. True, expectations of higher demand and lower supply do add upward pressure on futures prices and, in turn, spot prices today. But since longer-term supply and demand expectations regarding China and India are “old news,” they are to a great extent already priced into the market and thus cannot by themselves trigger an oil shock of the magnitude we are seeing now.

Hard truths

Let’s start with the facts. As the Energy Information Administration (EIA) detailed in its latest short-term energy outlook, world consumption of oil is continuing to grow despite 7 years of conscutive increases in oil prices, with decreases in demand from the U.S. being more-than offset by increases from places like China and the Middle East. Meanwhile, the pace of supply growth in non-OPEC countries is expected to continue to fall short of expectations and consumption growth - as it has in years past - thanks to faster declines in older oil fields and delays in expansion projects.

[For more information on these fundamental trends, check out the EIA's slideshow, "Next Stop for Oil Prices: $100 or $150," available here. Hint: it was written by economists, so the answer, of course, is "it depends."]

No one denies that these are the cold, hard facts on the ground (or rather, underneath). But what is of interest is how these longer-term realities impact prices today and where the rational limits of that impact lie. It is here that the plot thickens.

High expectations

The answer to the first question can be found in the role that expectations play in the oil market. As supply and demand conditions get more and more attention in the business press, sellers of oil have more reason to expect that they can capture a better price tomorrow than today and are therefore more likely to hold on to the marginal barrel of oil for sale at a future date. As a result, we’ve seen a steady upward revision in sellers’ future price expectations. For example, the price of crude oil for delivery in 2011 has more than doubled since January 2007, rising to $120 in May 2008, as economist Stephen P.A. Brown of the Federal Reserve Bank of Dallas illustrates in this chart from his article, “Crude Awakening:”

But how does a rise in futures prices impact spot prices today? As with many financial instruments, oil is priced over a benchmark - similar to a loan being quoted as LIBOR plus a credit spread. In the past, this benchmark used to be based on spot prices for certain crudes, such as West Texas Intermediate (WTI) or dated Brent. However, as this somewhat technical, but clearly-written and well-sourced post from the blog “Peak Oil Debunked” explains, since the mid-1980s, the oil industry has gradually shifted away from spot benchmarks to benchmarks based on futures prices because the former are easier to manipulate and corner than the latter. So when you see oil prices surging higher, what you’re seeing is a price formula that reflects changes in a weighted average of futures contracts for certain “benchmark” crudes (the WTI benchmark for U.S. oil, the Brent benchmark for oil sold by the Middle East to Europe, the Dubai-Oman benchmark for Middle East oil) plus a premium or minus a discount. Thus, higher futures prices lead to higher spot prices today.

This is why the venerable Economist was wrong when it argued in its July 3rd edition that futures contracts are simply “bets on which way the oil price will move” that “do not affect the price of oil any more than bets on a football match affect the result.” If football games were won by taking a weighted average of expectations over which team will win and then adding or subtracting some points for actual team performance, then the analogy would be apt. But since oil futures act as the benchmark for spot prices and therefore directly impact their levels, it is not.

So it’s clear that the bleak global supply and demand outlook is helping drive oil prices higher; here there is no bone to pick with analysts, the business press and talking heads. Instead, there is only the caveat that this is happening because of the way oil is priced over futures benchmarks - not spot prices.

Old news

Still, there is a hard limit as to how big the impact of this upward pricing pressure can be. That’s because none of the bleak macro supply and demand projections are news to investors. That is, it’s not as if late last year the world all of a sudden realized that India and China have very large and rising energy needs. We’ve known about this for years and it’s been priced into the markets for years. And at the end of the day, markets react to new information, not old news. Thus, unexpected announcements of buildups in oil inventories will move the needle one way or the other, but having a talking head on TV say that demand from China and India is growing doesn’t add any new information that hasn’t already been priced into the market.

Hence, the same old story of rising demand from India and China couldn’t by itself trigger such a precipitous rise in prices: it needed a spark. And that spark - as with the depreciating dollar and (as I will argue in a future post) speculation - came from the onset of the credit crunch. After the debt markets shut down last summer, billions of dollars that couldn’t be invested in debt securities went looking for a safe haven, which they found in the commodities markets. As I will explain in a future post on the role of speculators, this had an upward impact on the price of futures contracts and - via the same pricing formula desribed above - on spot prices. And once this happened, everyone from the business press to Treasury Secretary Hank Paulson and the EIA reiterated the tight supply and demand picture, which only exacerbated the panic and reinforced expectations of higher oil prices in the future.

This suggests that supply and demand forces aren’t as powerful here as one might think. This becomes even more evident when we consider the fact that the bleak global supply and demand outlook is a longer-term macro trend which stays pretty constant over time. That is, we know that China and India are probably going to be consuming more oil over the next few years and that supplies in non-OPEC countries will likely not keep pace with demand. But consider the fact that between the beginning of March and the middle of June nothing much changed in this fundamental supply and demand picture while the price of oil nevertheless jumped nearly $40/barrel over the same period. To say that this jump was all due to fundamental demand from India and China and tight supply in non-OPEC countries would be like explaining a particularly hot summer day by referencing global warming. Point being: it’s a long-term trend whose explanatory power diminishes as we focus on short-term oil shocks rather than gradual price increases over longer periods of time.

So yes - tight oil supply and real growing demand are powerful forces and serious problems that need to be dealt with. But their impact on the price of oil likely takes a passenger seat to the depreciating dollar and - as I will argue in my next post - the impact of speculators.

I originally wrote this as one post reflecting on the trends and catalysts behind the rapid increase in oil prices. But after receiving feedback from readers, I decided to split it up into three shorter posts that examine each of the long-term trends more in-depth. The following post examines the first trend: dollar depreciation.

As oil prices continued their drop today, falling more than $18 since last Friday, analysts and commentators began to question whether oil is finally in retreat thanks to any one of a variety of pet causes and issues blamed for its dramatic rise.

But much to the chagrin of scapegoaters everywhere, unlike in years past - such as in 1973, when the OPEC oil embargo caused prices to spike - there really isn’t any one central factor that we can squarely pin the blame on for rising oil prices. Instead, three long-term trends that have been converging since the early 2000s - dollar depreciation, tightening global oil supply combined with rising demand, and increasing commodity price speculation - provided the powder keg, while the fallout from the credit crunch lit the fuse that caused oil prices to explode so fast and furiously.

Over the next three posts, I will examine each of these trends in turn - beginning with Congress’s current favorite: the depreciating dollar.

Mind the gap

As fears over Fannie Mae and Freddie Mac recently brought the dollar within a penny of its record low against the Euro, members of Congress have increasingly focused on the depreciating dollar as the source of and solution to all our woes. Witness Congressman Ron Paul (R-TX) informing us at Tuesday’s biannual Humphrey-Hawkins hearing that we don’t need “a world-class regulator that is going to solve all our problems” but rather “a world class dollar - a dollar that is sound, not a dollar that continues to depreciate.”

To be sure, as Chairman Bernanke acknowledged in his testimony, the falling dollar has definitely played a role in oil’s spectacular rise over the last year. To see why, just look at the gap that’s been slowly emerging between the price of oil in dollars vs. gold:

While the price of oil in dollars has nearly doubled, the price of oil in gold has risen by 50% over the same period. This discrepancy becomes an even more jarring 3-to-1 if we turn the clock back to late 2001, when the dollar began its tumble. Small wonder that in January of this year the Financial Times crowned gold as “the new global currency.”

This has led some economists - notably Stephen P.A. Brown at the Federal Reserve Bank of Dallas - to estimate that the depreciation of the dollar is responsible for a large percentage of the rise in oil prices over the last seven years. “If the U.S. currency had held its 2001 value against the Euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price,” Brown wrote in May. And as if that weren’t high enough, in early July - sourcing Brown - New York Times business columnist David Leonhardt cited this gap as $31.

Symptoms of addiction

The dollar depreciation trend only became exacerbated by the onset of the credit crunch, which forced the Fed to slash interest rates at a time when federal banks around the world were hiking interest rates to stem inflation pressures. Consequently, the already-weakened dollar plunged even more and the changes in dollar-denominated oil became even more pronounced.

To see why, think back to America’s “addiction” to foreign oil. The United States currently imports over 70% of its oil as a way to meet its energy needs. During times of elevated oil prices, this dependency leads to large capital outflows from the U.S. to the rest of the world (what Texas oil tycoon-turned-environmentalist T. Boone Pickens called “the largest shift of money in the history of mankind” in a recent interview with the Chicago Tribune editorial board). And just as strong capital inflows tend to strengthen the dollar - as they did throughout the 1990s and early 2000s when central banks around the world were selling their gold reserves and buying up dollars - strong capital outflows tend to weaken it. The result: a vicius cycle in which oil becomes more expensive but the U.S. continues to buy it at a higher price, adding more downward pressure on the dollar, upward pressure on oil, and so on and so on.

Possible cure

Naturally, one way to break that cycle is for the U.S. to import less oil. But as global oil demand from places like India and China surges, decreased domestic demand is unlikely to make a big dent in the price of oil. Oil demand is, after all, highly correlated to income and, as Brown of the Dallas FRB points out, China’s GDP per capita rose from $1,103 in 1990 to $4,088 in 2005 while India’s went from $1,202 to $2,222 over the same period (adjusted for inflation and purchasing power parity). Couple this with the sober fact that non-OPEC supplies of oil have consistently been lower than what the industry has expected and what results is the second long-term trend that’s been driving oil prices higher: tight global supply and demand conditions.

More on this in my next post in this series.

Yesterday most major U.S. stock indexes finished the day either flat or slightly lower as markets await with anticipation to see what action the Fed will take at the end of its two-day policymaking meeting that starts today.

It’s a sort of nervous quiet-before-the-storm that comes whenever the markets anticipate a change in direction in Fed policymaking. But this is not just a drizzle; investors are curious to learn how what the Fed’s next step will be in tackling what seems to be the perfect storm of sky-rocketing commodities costs, soaring inflation and a plummeting dollar.

After nine months and 325 basis points of easing, fed funds futures are overwhelmingly pointing to a halt in easing - to be exact, an 87% probability (as of June 20th) that the FOMC will leave the Federal Funds Rate target unchanged, as calculated by the Cleveland Fed.

This comes as no surprise since most economic indicators still point to an uncomfortable netherworld between contraction and expansion that seems to call for a pause and rethink of where the economy is going. The index of Leading Economic Indicators (LEI) - a composite of a group of 10 macroeconomic statistics that are known to change in advance of a contraction or expansion - despite moving higher by a slight .1% last month, gave us little insight since six of the ten components moved down and October through February marked a period of -1.8% contraction in the LEI that fell just shy of predicting a recession (according to the rule of thumb of 2% decline in the index over six months and a majority of components moving lower).

No matter what it decides to do, the Fed will likely highlight this uncomfortable netherworld situation in its statement on Wednesday, warning us of the continuing downside risk and the need to monitor the inflation situation closely.

Important as this may be, though, the real words to watch for in its statement - given recent statements by Treasury Secretary Paulson and Fed Chair Ben Bernanke - will be the dollar and commodities, both of which have been enjoying increasing popularity on Capitol Hill and the campaign trail lately, and for obvious reasons.

Since Mr. Bernanke has taken over as the chairman of the Fed, the dollar has depreciated in value against most of the world’s major currencies (this clever graphic from the Telegraph says it all) - a decline that has only thrown more fuel on flame-hot commodity prices, which have become increasingly correlated with the depreciating dollar over the last year. This should come as no surprise: after all, with credit markets frozen and falling interest rates at home, where were investors to park their money except foreign currencies and a booming commodities market?

Still, as anyone who regularly reads the FOMC’s carefully-crafted and blandly worded policy statements knows, the Fed is unlikely to make a big splash about commodities and the dollar. Nonetheless, investors are curious to know whether all the talk of bolstering the dollar and reigning-in commodities prices really has any policy teeth behind it - which is why the reason behind the Fed’s staying the course, if it does so, will be particularly illuminating.

If it cites the threat of inflation as its primary policymaking motivation, then the case could be made for a prolonged wait-and-see approach since inflation is a lagging economic indicator. On the other hand, if it cites worries about the plummeting dollar and its impact on soaring commodities prices, then there is a strong argument to be made that there is little time to waste since both are already at historic lows and highs, respectively. As a result, the Fed will be expected to raise rates sooner rather than later, (in which case expect to see the implied probability of a 25 bps increase in August edge higher than the current ~20%).

But whether it’s soaring commodity prices, inflation, or a plummeting dollar, at the root of each - as well as their after-shocks in the over-heated housing markets - lies the 2001-2004 Fed easing cycle carried too far and too long. This is why some economists, including Dr. Benn Steil, Director of the International Economics Council on Foreign Relations, have wisely begun to point out that we are currently experiencing not so much the beginning of (yet!) another bubble, this time in commodities, but rather the aftermath of a previous, much larger currency bubble. As Steil testified two weeks ago in front of the Senate Committee on Homeland Security and Governmental Affairs, “the Federal Reserve pushed rates too low and held them too low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation.”

The “since last autumn” part is, of course, how we got to this spot in the first place, and doing so again will only continue to widen the yield gap between the United States and the rest of the world, including oil-rich states like Saudi Arabia, which last year for the first time refused to lower its interest rates in lock-step with the U.S. Federal Reserve.

A telling sign of the times? Certainly; but more so a reminder not to repeat the mistakes of the past - even in the face of the perfect storm.