In the wake of the U.S. Presidential election on November 8, the dollar broke out to the upside after a long twenty month period of consolidation. The dollar was under 79 on the nearby dollar index futures contract in May of 2014. Over the next nine months, the greenback exploded higher to just over 100 by March 2015. The rally of over 27% in the reserve currency of the world in such a short time is not the norm. Currency volatility tends to be low as central banks and monetary authorities around the globe manage currency movements. At times, currencies detach from one and other because of fundamental changes in an economy. That is what happened in May of 2014 when it comes to the dollar. The policy of quantitative easing ended in the U.S. and the central bank warned the market to prepare for short-term interest rates to rise from the zero level. While economic growth in Europe and Asia continued to be problematic, moderate growth in the U.S. caused the dollar to rally sharply versus other world currencies.
The dollar went back to sleep after the nine-month rally in 2014-2015 but recently it broke above technical resistance at 100.60 and reached a high of 102.12 on November 24. A strong dollar is rarely good news for raw material prices.
The dollar and commodity prices
On a historical basis, a strong dollar tends to be bearish for commodity prices. The dollar is the reserve currency of the world and the benchmark pricing mechanism for most raw materials. When the dollar moves higher, the price of commodities in other currency terms increases. Classic economic theory teaches that higher prices encourage selling by producers while at the same time inhibits buying by consumers. For those commodities produced in nations around the world, a strong dollar means weaker local currency and higher local commodity prices. Click to enlarge Source: CQG
As the daily chart of the U.S. dollar index shows, the greenback has moved appreciably higher since November 9 when it fell to lows of 95.905. The dollar moved above the 100.60 resistance level to the highest level since 2003.
Brazil is one of the most important commodity producers in the world. When it comes to sugar and coffee, Brazil is the leading producer and exporter of both agricultural commodities. When the Brazilian real moves lower, coffee and sugar prices in real terms move higher. Click to enlarge Source: CQG
As the daily chart of the Brazilian real highlights, the strong dollar caused the real to slip lower. The weaker real has caused both sugar and coffee to correct lower after some impressive gains over recent weeks and months.
Sugar gets less sweet
As the weekly chart shows, sugar took off from lows of 10.13 cents per pound in August 2015 and reached highs of 23.90 on the March ICE futures contract in early October of this year. Sugar rallied because the real strengthened and a supply deficit gripped the market. However, the recent fall in the real has inflicted more damage to the sugar bull. After the election, as the dollar appreciated, sugar fell below 20 cents per pound for the first time since early September when it was on its way to the recent highs. While the fundamental deficit in the sugar market remains in place, technical support now stands at the 18.7 cent level.
The prospects for sugar could depend on the dollar-real relationship over the coming weeks. While I do not expect sugar to give up a majority of the gains achieve over the past year due to the positive fundamentals in the market, the sweet commodity is likely to track movements in the currency market.
As the weekly chart of March ICE coffee futures illustrates, coffee began making higher highs and higher lows in early March of this year. The price rallied from $1.1135 during the week of February 29 to highs of $1.76 per pound during the week of November 7. The increase of over 58% was due to strong fundamentals. A shortage of Robusta beans spilled over to the Arabica market and an "off-year" in Brazilian production caused the price to appreciate. However, the stronger dollar and weaker real has recently caused a correction which has taken the price down to the $1.60 per pound level. Key support for March coffee futures is now at the $1.4520 level. Below there, coffee would negate the bullish pattern of higher lows that has been in place for most of this year.
Cocoa has many issues
During the bear market in commodities that took hold of the market from 2011 through early 2016, cocoa enjoyed positive fundamentals and the price made a series of higher lows and higher highs. Click to enlarge Source: CQG
As the weekly chart of ICE cocoa futures shows, the bull market in cocoa came to an end in December 2015 when the price traded to $3422 per ton. Cocoa had a few more attempts at the highs trading up to $3224 in May 2016 and then $3237 in June just before the Brexit vote. Over 60% of the world's annual supply of cocoa beans comes from the West African nations of the Ivory Coast and Ghana. London is the hub for international physical cocoa trading. When the pound sterling tanked after the U.K. voted to exit the European Union, the price of cocoa moved higher in pound terms and selling hit the market like a ton of bricks. The pound fell from $1.50 to $1.25 against the dollar in the wake of the Brexit referendum. Since then the price has made lower highs and lower lows falling to lows of $2361 in November, the lowest level since August 2013. Additionally, supplies of cocoa beans are on the rise with both West African producers increasing production this year causing further pressure on price.
Cocoa is another example of an agricultural commodity market where the strong dollar, and in the case of this soft commodity, weak British pound, has caused the price to drop. In cocoa, more supply is adding insult to injury when it comes to the price of the soft commodity.
Cotton is still cheap
As the monthly chart illustrates, ICE cotton futures plunged to lows of 55.66 cents by March 2016. Cotton swooned as inventories grew to the highest level in years. Since then the price action has become constructive as the price became so very cheap. The low price of the fiber has led to an increase in exports to China and inventories have begun to decline. Click to enlarge Source: CQG
The daily chart illustrates that cotton is trading in a range between 65.85 cents and 72.75 cents since early September with an upside bias; the lows have been progressively higher. The strong dollar has likely weighed on the fiber as it makes U.S. exports of cotton less attractive on the global market. However, the potential for cotton to rise to the August highs and perhaps above the 80 cents per pound level in the months ahead remain high.
The strong dollar has weighed on the soft commodity sector. In sugar and coffee, where fundamentals remain strong, the dollar has stopped the upward trajectory of those markets, for now. In cotton, the price remains low so the influence of the dollar has not been as great. When it comes to cocoa, a combination of bearish fundamentals and a strong dollar have put a four-year bull market to sleep and a bear trading pattern has emerged.
Fundamentals, weather in producing countries and the dollar will dictate the path of least resistance for soft commodity prices. Each of these tropical markets has individual supply and demand characteristics. I remain friendly to sugar and coffee, bullish on cotton and bearish on cocoa for the medium-term. The strong dollar has weighed on this sector of the commodities market since the greenback broke above the resistance level at 100.60 on the December dollar index futures contract. If you trade soft commodities, keep an eye on the dollar because it is an important factor when it comes to the path of least resistance for prices.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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