The Dollar Holds The Key For Commodities

Summary

• The big rally ends, for now.
• Approaching bear market territory.
• Europe, Japan and now the Saudis.
• Fundamentals still favor the dollar, but central bank policy is irrational.
• Volatility ahead.

The U.S. dollar is the reserve currency of the world because of the relative stability of the U.S. economy. That is why the dollar is the pricing mechanism for raw materials or commodities all over the world. There is an inverse relationship between the prices of commodities and the dollar. When the dollar appreciates, commodities tend to move lower. When the greenback declines, commodities tend to appreciate in value.

People all over the world consume commodities. While output occurs in locations where geology or climate allows for production, consumption is ubiquitous around the world. Each commodity has individual idiosyncratic characteristics and fundamentals. However, as an asset class, when the dollar moves higher, commodities become more expensive in other currencies. There are over 7.3 million people on planet Earth and fewer than 324 million, or less than 4.5%, live within U.S. borders. Over 95% of the world operates in currencies other than the dollar. A higher dollar results in higher commodity prices in other currencies. Basic economics teaches us that as prices increase demand decreases. When the dollar moves lower, the opposite occurs. While there are always other considerations, the future path of the dollar will likely have an important influence on the path of least resistance for commodity prices.

The big rally ends, for now

Currencies tend to be stable financial instruments. That is because the mission of central banks around the world is to provide stability via tools like interest rates or other monetary policy instruments.

Beginning in May 2014, a massive rally in the dollar occurred. The dollar index was trading at 78.93 in May 2014; by March 2015, it had rallied to 100.38 - an increase of over 27% in 10 months. The historical volatility of currencies tends to be much lower than in commodities. As the chart highlights, weekly historical volatility of the dollar index is currently around 7.70%. By comparison, weekly volatility of crude oil stands at 39.36%, for gold it is 11.33%, and in sugar, the variance measure is 34.72%. Therefore, the 27% rally in the dollar was the exception rather than the norm. The rally in the dollar exacerbated the bear market in commodity prices which commenced in 2011/2012.

After the rally in the greenback, it traded in a range of 92.5 to 100.60 for 13 months, a period of consolidation. The recent low came on August 24, 2015, when China shocked global markets with a devaluation of the yuan. The highs came in late November 2015 as the Federal Reserve prepared to hike interest rates for the first time in nine years. After a brief rally in January 2016, the dollar has declined. It is now approaching support at the August 24 lows and closed last Friday at 95.08 on the active month June dollar index futures contract.

While the dollar index has declined and displays an oversold condition, there are some important reasons for current dollar weakness. The U.S. Fed promised 3-4 more interest rate increases in 2016. Due to weak economic conditions around the globe, the central bank has yet to act. Disappointment resulted in selling in the dollar. However, this is not the only reason for the current bear market action in the dollar.

Approaching bear market territory

Important support for the dollar stands at 92.50 on the dollar index. The dollar is now approaching bear market territory. Dollar weakness has caused commodity prices to take off over recent weeks. While the dollar fell 4.22% during the first three months of 2016, a composite of the major commodities traded on futures exchanges rallied by only 1.63%. Commodities prices lagged action in the dollar; recently that has changed dramatically. As an example, as of last Friday, the dollar index is down 3.71% for the year, but many commodities have exploded higher. Crude oil is up 18% on the year and more than 67% since its February 11 lows. Gold is up 16.5% on the year, silver has rallied over 23%, and many other raw material prices have moved higher in 2016. Commodities had been in a brutal bear market since making highs in 2011/2012, but the recent technical action in this asset class suggests that they could be on the verge of a spectacular rebound. One factor that could ignite commodities is a further breakdown of the value of the dollar against other currencies.

Europe, Japan and now the Saudis

In February 2016, Mario Draghi fired a stimulative bazooka at the lethargic European economy. He slashed interest rates to negative 40 basis points. He increased the policy of quantitative easing from 60 to 80 billion euros each month, including corporate debt in the package. However, the ECB President told markets that he would not lower interest rates again. The certainty of his declaration about interest rates caused buying in the euro and selling in the dollar. That was the first nail in the dollar's coffin.

Last month, the Japanese central bank cut interest rates further into negative territory. The market greeted this move with selling in the dollar against the yen. The reason was that lower Japanese rates caused an unwinding of the yen carry trade. Last week, the Saudis, fresh off a victory with their intransigent stance on oil policy, cautioned the U.S. Congress that they intend to sell 750 billion in U.S. debt if a bill that would allow families of 9/11 survivors to sue the Kingdom passes. Concerns about a sovereign bond liquidation for political reasons add to the negative tone of the dollar.

The Fed meets again this week. The first three meetings of the year resulted in no changes in interest rate policy. At the March meeting, the Fed Chairperson introduced a new term in Fed-speak, "gradualism". While the Fed has told us that it uses domestic economic data as a guide for monetary policy, recent statements cite economic weakness around the globe and the potential of contagion on the U.S. economy as a reason for extreme caution. In essence, U.S. interest rate policy had been ceded to Brussels, Tokyo and Beijing over recent meetings.

Fundamentals still favor the dollar, but central bank policy is irrational

Based on previous Fed statements, the central bank is data driven. The U.S. economy continues to grow at a moderate pace. That is better than most other nations on the planet. Recent employment data has been positive, and although wage growth is tepid, the U.S. is close to or at full-employment. The Fed's stated target for inflation is 2%. While commodity prices fell during the first six weeks of 2016, recent action in raw material markets means that inflation is now heading toward the target rate. After all, a 67% increase in the price of oil since February 11 is inflationary, given the way the Fed measures the indicator. We will find out next week if the Fed acts to increase short-term rates or they stay put. Market consensus is that the Fed will once again do nothing.

The data is there for the Fed to raise rates in the United States. Central bank policy in Europe and Japan should be highly supportive for the greenback; after all, the U.S. currency pays a small yield these days while the euro and yen cost money to hold due to negative interest rates.

I can make an argument that central bank policy around the world is irrational. Cheap money floating around the world is creating mountains of debt. By encouraging spending and borrowing and discouraging savings, the central banks are sowing seeds of inflation. I can also make an argument that market reaction to central bank policy is irrational. Is it the act of a sane market to sell the dollar when Europe and Japan slash rates further into negative territory when the next move by the U.S. central bank is likely to be a rate hike? I think not.

Meanwhile, as the weekly chart of the dollar index highlights, while momentum is lower and support is close, the dollar is in oversold territory, and a recovery rally seems possible. As I wrote in my recent article for Seeking Alpha, Why I Changed My View On The Dollar:

"I certainly hope that the central banks understand what is going on in the international currency markets. If they are as baffled as I am, then we could be in for some real problems and volatility in the global economy. Perhaps that is why the best performing asset these days is gold, the hybrid between a currency and commodity that the central banks of the world love to hate the most because they cannot print more."

I wrote that article on April 11, and the dollar index is at the same level today. I continue to believe that markets are irrational when it comes to the dollar's relationship with other currencies for both fundamental and technical reasons.

Volatility ahead

Given recent action in the dollar, I would not be surprised if the Fed decided to hike rates this week and the dollar moved lower. That would be consistent with recent moves after Europe and Japan cut rates, and the dollar moved lower. I guess anything is possible these days.

Chances are we will see major commodity prices follow the dollar over coming sessions. Precious metals, non-ferrous metals, crude oil, grains and some soft commodity prices have been rallying in the face of dollar weakness. We could be in for lots of volatility in both commodity and currency markets this week. A continuation of "gradualism" and no changes in interest rate policy from the Fed this week could ignite commodities for another leg higher. However, if the Fed acts rationally and fulfills its promise from December, we are likely to see a pullback in these markets.

The interesting thing to consider is that while the dollar has not yet fallen below key support, some commodity prices have broken long-term resistance over recent sessions. Precious metals have been buoyant with silver and platinum rising above their resistance levels last week.

Precious metals are money that central banks cannot control; they are the ultimate store of value and symbols of wealth. Central banks cannot turn on the gold, silver or platinum printing presses like they can with paper money. The value of currencies depends on the full faith and credit of the nations that print bills and mint coins. Gold, silver and platinum have moved appreciably higher in 2016 suggesting that faith in central banks and monetary policy is becoming suspect.

My suggestion to Janet Yellen and company is to heed the warning these financial commodities are flashing. They are now flying like doves, and only a hawk can slow or stop the rallies. Action in the dollar will tell us if we are at the gateway to a new bull market in commodities or if we are seeing a bear market rally. We are likely to get some clues this week as the dollar holds the key to the path of least resistance for commodity prices.

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.