The Dollar And Divergence In Commodity Markets

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Includes: BCM, CMD, CMDT, COMT, CSCB, CSCR, DBC, DDP, DEE, DJCI, DJP, DPU, DRR, DYY, ERO, EUFX, EUO, FTGC, FXE, GCC, GSC, GSG, GSP, LSC, PDBC, RJI, SBV, UCD, UCI, UDN, ULE, URR, USCI, USDU, UUP, XLE
by: Andrew Hecht

Summary

A bullish 2015 and a choppy start 2016.

The interest rate factor.

The commodity factor divergence with a capital D.

An election year for the U.S., but not a correction year for the dollar.

Parity against the euro in 2016?

2016The first week of 2016 was a wild one. The Chinese stock market plunged by more than 10%. The political situation in the Middle East deteriorated as Saudi-Iranian relations sunk to a new low. North Korea flexed their muscles by testing what could have been a hydrogen bomb last week. Markets are a reflection of world events and during the first week of the year, we have seen markets move big time. Copper and crude oil, two bellwether commodities, both posted new multi-year lows during the week. Copper lost a quarter of its value in 2015 and crude oil lost almost one-third of its value. Both are now trading at even lower prices in 2016. Most commodity prices have moved lower in 2016, with the exception of gold and silver, which both posted early January gains perhaps because of fear-driven buying.

Meanwhile, the U.S. dollar had a choppy week but it closed last Friday at a level very close to the closing level of 2015. The dollar remains strong.

A bullish 2015 and a firm start to 2016

The bull market in the U.S. dollar index began in May 2014 when it made lows at 78.93. Since then it has strengthened, making a new high at 100.60 at the end of November and consolidating just below the 100 level. It closed 2015 at 98.745 and last Friday at 98.599 on the active month March futures contract. Click to enlargeThe dollar index has been a rock; it appreciated by 8.93% in 2015. The prospects for 2016 continue to be positive for the U.S. currency.

Europe continues to suffer lethargic growth. Unemployment is at high levels on the continent and the central bank continues to use monetary policy, through their quantitative easing program, in an attempt to stimulate the economy. Additionally, ever-increasing tension in the Middle East continues to provide a seemingly endless flow of refugees into Europe, straining the already tenuous economic resources of many nations in the eurozone. Moderate growth in the U.S. caused the euro to fall 10.09% in 2015 against the dollar, and that growth trend appears to be intact for 2016.

The dollar is also stronger against the currencies of nations that depend on commodity production for revenue. The greenback appreciated dramatically against the Russian rouble and the Brazilian real in 2015. It was up over 10.5% against both the Australian and Canadian currencies in the year that ended on December 31, 2015. In early 2016, these currencies have continued to weaken against the U.S. dollar.

In Asia, the government devaluation of the Chinese yuan against the dollar virtually guarantees a continued appreciation of the U.S. currency against the yuan. Other Asian currencies are likely to weaken against the dollar in the months ahead in sympathy with the Chinese currency. Additionally, a potential hydrogen bomb test by North Korea last week is not a supportive factor for Asian currencies.

Meanwhile, interest rate differentials may provide the strongest case for dollar appreciation in 2016.

The interest rate factor

In December, the U.S. Federal Reserve raised the short-term interest rate for the first time in nine years. While the Fed Funds rate only rose by 25 basis points, the Fed stated that it is likely that they will continue to raise rates in 2016 and the market should expect 3-4 similar rate moves in the New Year. Any future increases in U.S. interest rates will be data driven, but the trend is clearly higher for short-term U.S. rates. Employment data last Friday was consistent with Fed expectations and supportive of a continuation of the tightening policy of the central bank.

Meanwhile, the rest of the world continues to mire in economic lethargy or worse. Central banks around the world are still scrambling to stimulate economies. The action in the Chinese stock market last week unleashed a slew of governmental policies to deal with plummeting equity prices as the target growth rate becomes more elusive. It is likely that more interest rate cuts in China are on the horizon for 2016. The central bank cut domestic rates six times in 2015.

QE in Europe will continue throughout 2016. This will keep rates at or below zero. At the same time lower commodity prices will continue to depress the economies of countries that produce raw materials, thus putting downward pressure on rates. The current trend of interest rate differentials between the dollar and virtually all other currencies is a supportive factor for dollar appreciation in 2016.

The commodity factor divergence with a capital D

The dollar is the reserve currency of the world and it is the pricing mechanism for most commodities. A strong dollar has contributed to the bear market in raw material prices, which now enters its fifth year. However, each commodity has its own idiosyncratic characteristics. While the dollar has a direct affect on the level of commodity prices, so does weather, geopolitical events and individual supply and demand characteristics. Right now inventories are at very high levels in many raw material markets. This weighs heavily on price.

Additionally, lower energy prices have caused the cost of production to drop for many metals and minerals. This lowers the bar for producers to sell production as a key input cost has depreciated dramatically. When it comes to the dollar and commodity prices, it may be a case of the tail wagging the dog. While a stronger dollar will drive raw material prices lower, lower commodity prices due to other factors will drive the dollar higher.

The current state of commodity markets has unveiled a number of important divergences that have developed within commodity markets themselves and across other asset classes. In the precious metals sector, the price of gold remains strong relative to the price of other precious metals. Platinum, a rarer precious metal with a higher production cost and myriad industrial uses, remains at historical lows relative to the price of gold. Silver, gold's little brother and an industrial precious metal, continues to trade at a level against gold, which is far below modern-day historical norms.

In the energy sector, prices have dropped like a stone over recent years with crude oil and natural gas making multi-year lows in 2015. Last week the price of crude oil dropped to the lowest level since February 2003 and closed just over $1 per barrel above the lows of the week. However, the price of oil-related stocks as exhibited by action in the Energy Select Sector SDPR (NYSEARCA:XLE) remains above the 2011 lows. While oil has dropped, the shares of companies in the oil patch have not depreciated to the same extent. This could be a dire warning for equity markets in general in the weeks and months ahead. Since so many market indices in the U.S. contain oil-related companies, the weakness in this sector is likely to translate into falling equity prices and volatility in the stock market in 2016. We have already seen weakness in equity prices during the first week of the year, however, that weakness relates to market action in China and the oil market could be the reason for the next shoe to drop in the stock market.

We are going to see lots of volatility in markets in 2016. A dramatic market correction may have already begun and another event promises to add some fuel to the fire.

An election year for the U.S. but not a correction year for the dollar

One thing is for sure in 2016, the United States will elect its 45th President. So far, the campaign has been nothing short of a circus. The Democratic Party will almost certainly nominate Hillary Clinton. The Republican Party nominating process is likely to be a free-for-all. The current leaders in the polls, Donald Trump and Ted Cruz, are not typical party candidates. In fact, both represent factions that are a rejection of politics as usual. Whoever is nominated on each side, the election that will pit one party against the other is likely to be the perhaps the most contentious and entertaining election of our lifetimes. There are stark political divisions within the United States.

With so many events transpiring around the world, with the constant threat of terrorism and with a shaky stock market at the start of 2016, rhetoric during this election season could add to market volatility to an extent not seen in past election years. The first primary is less than one month away and now election antics will kick into even higher gear. Regardless of who gets each nomination or who wins the general election, the fundamentals for the dollar remain strong. It is not so much the underlying strength of the U.S. economy, but the underlying weakness of other countries that support the dollar.

Parity against the euro in 2016?

The dollar has appreciated by 25% since May 2014. Last year it was up by just under 9%. The technical and fundamental pictures for the U.S. currency favor a continuation of a stronger dollar in 2016. The dollar closed at just over the $1.09 level against the euro on Friday, January 8, 2016. I expect 2016 to be the year that the dollar trades at parity against the euro currency. For the dollar, all signs point to stability and appreciation in a world where volatility and divergence is likely to be the standard for most asset classes. This is bad news for commodity prices, which just began the fifth year of the secular bear market.

As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on the dollar to illustrate the real value implications and opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.