The long-in-the-tooth commodities correction plunged to new lows this week. Traders were disappointed the Fed didn’t announce a new quantitative-easing campaign, so they dumped the popular commodities with a vengeance. But realise the primary driver of the recent commodities weakness is not the Fed, but a strengthening US dollar. The coming commodities price action heavily depends on its fortunes.
This strong interrelationship between commodities and the US dollar is perfectly logical. Thanks to the United States’ economic dominance over the past century or so, commodities are generally priced in dollars globally. While they have local-currency prices, the great majority of the time these are actually a direct function of a commodity’s global dollar price and that local currency’s exchange rate with the dollar.
As capital inflows bid the US dollar higher in the global marketplace, this reserve currency strengthens. And the more highly valued it is, the fewer dollars are necessary to buy a given unit of commodities. Thus futures traders around the world have long been conditioned to sell commodities when the dollar’s price is rising. And the inverse is true for a weakening dollar, it ignites universal commodities buying.
The recent commodities correction is not a fundamental prediction of a weakening global economy as the financial media loves to claim, but the simple mechanical result of a rallying US dollar. So speculators and investors interested in commodities and the companies that produce them need to focus on the US dollar for insights. Why is it rallying, how high will it likely go, and when will it turn south again?
Answer these questions, and you will get a great idea of where commodities are heading over the near term. But first, the strong inverse correlation between commodities and the US dollar couldn’t be clearer on the charts. The best proxies for each are the Continuous Commodity Index (CCI) and the US Dollar Index (USDX). The whole commodities story in recent months is simply the strengthening US dollar.
Since spring, the USDX has surged higher three separate times. I highlighted these big dollar rallies in red. In May this flagship dollar index climbed 4.4% in just over 3 weeks, straddling September it blasted 7.9% higher in just under 5 weeks, and in the past 7 weeks or so it has surged another 7.4% higher. Realise these are huge moves for the world’s reserve currency, which usually moves at a glacial pace.
Note above that the entire commodities correction since late April happened during these major dollar rallies! If you look at the sharply-falling blue CCI line within those red dollar-surging zones, the overlap between all three more than accounts for every bit of the past half year’s commodities weakness. Commodities have been struggling simply because the dollar has been strengthening, full stop.
Back in late April, this flagship commodities index actually hit an all-time high. The global commodities market was robust and investors were excited about commodities’ global supply-and-demand fundamentals. Then commodities started correcting in May, which is healthy and expected within any ongoing bull market. It was the 14th correction of commodities’ decade-old secular bull, no big deal at all.
Periodic corrections are essential to keeping sentiment balanced, which prolongs the ultimate longevity of bull markets. So they are utterly inevitable. Still, it is typically some external catalyst that sparks a particular correction at a particular time. And in May it was the sharply-higher US dollar. Why did the dollar start rallying then? As I wrote at the time, it was simply oversold so a bear-market rally was due.
That rally to rebalance away excessive fear in the dollar didn’t last long, and the moment the USDX started grinding sideways again so did the CCI. This was even true in early August, an extraordinarily-scary time in the US stock markets. As you recall, Obama’s profligacy forced the first-ever downgrade of US Treasuries in this nation’s history. Stock markets plunged while fear rocketed up to its effective ceiling.
Yet over that frightening 2-week span when the benchmark S&P 500 stock index collapsed by 16.8%, the CCI only lost 5.3%. Commodities losses ran only about a third as deep as the stock markets’ because the dollar barely budged despite the extreme fear. The USDX was only up 0.6% over that span, so there was no currency catalyst to frighten futures traders into another wholesale exodus from commodities.
For several reasons, those early-August lows looked like the bottom in the commodities correction at the time. The CCI was down 10.7% by that point over a 3.6-month span. The average CCI correction in the decade before that (excluding the brutal stock panic) was 8.8% over 1.6 months. 11% was about as big as commodities corrections got with the exception of that once-in-a-century stock panic.
In addition the CCI was very oversold by early August, trading at 0.968x its 200-day moving average. Normally when this slow-moving equally-weighted geometrically-averaged index falls below its 200dma, it is a great buying opportunity. And if the US dollar couldn’t rally significantly despite early August’s massive fear spike, then what could possibly drive major dollar buying? That really should have been the commodities correction’s bottom, so we loaded up accordingly on beaten-down commodities stocks in August.
But alas, the markets are a probabilities game and sometimes the least-likely outcome still flares up to scuttle even great opportunities. The resilient and fully-corrected-by-bull-to-date-standards CCI started plunging on a gigantic US dollar rally in September. This unforeseen event was extremely unlikely based on dollar sentiment and technicals heading into that month, but it happened anyway.
Several drivers contributed to the USDX’s anomalous strength. Chief among them was weaker US stock markets. Ever since 2008’s once-in-a-century stock panic, the USDX has tended to surge whenever the stock markets are weak enough to spawn meaningful fear. Though this tendency curiously failed to work in early August’s sharp selloff for some reason, it is powerful and crucial to understand.
The most-important US economic report that month was released in early September, when US jobs growth came in sharply lower than expected. Even though that was an erroneous read subsequently revised away the following month, it ignited widespread fears of a US recession. On top of this Europe was a mess as always, its leaders inanely diddling while global investors exited troubled sovereign debt.
The dollar’s rally higher accelerated later in September on a non-news development. Even though the Fed had been telegraphing for months that it wasn’t going to embark on another inflationary quantitative-easing campaign anytime soon, currency traders were still relieved that the Fed didn’t launch one. So the dollar surged. This happened again near the Fed’s early-November meeting, and again this week.
While the steep commodities selloff straddling September was way overdone, its cause was inarguably the surging US dollar. When weak stock markets, recession fears, Europe worries, whatever, lead capital to flood into this safe-haven reserve currency, commodities get hit. But the CCI plunging 14.8% on a 7.9% USDX rally was very excessive, as the CCI hit hyper-oversold levels not seen since the stock panic.
Of course the US stock markets were radically oversold too heading into October, when the irrational US-recession fears founded upon a single bad data point peaked. That month the S&P 500 rocketed 10.8% higher in its best month in two decades! And look what happened to the US dollar as stock markets surged. Flight capital hiding in this zero-yielding parking lot quickly exited, and the USDX plunged.
Commodities immediately started rallying sharply, and didn’t stop until late October when the USDX started powering higher again. What drove it that time? More Europe fears. Just as Europe had finally scraped together a deal to bail out overspending Greece, the socialist Greek Prime Minister dynamited the entire package. So the euro collapsed that day. And since it accounts for 58.6% of the USDX’s weight, the dollar rocketed.
And naturally what happened to commodities? Again they were crushed, as the strengthening dollar led to widespread futures selling. There was nothing wrong with commodities’ bullish fundamentals, as they take years to change. The only reason commodities spiraled lower again was because the dollar was strengthening. This rally continued throughout November, driven by a sad comedy of European blunders explained in our current monthly newsletter.
By late November, the USDX regained its early-October high. Seriously overbought both times, it looked like a double topping. Indeed the CCI stabilised and started rallying again immediately heading into December. But an event transpired this week that pushed the USDX a bit above its topping levels and hammered the CCI lower still. The absurdity of this episode just blows my mind, I can hardly believe it.
Ever since the Fed’s last quantitative-easing campaign ended at the end of June, the FOMC has been very clear in communicating that it wouldn’t monetise more Treasuries unless something very dire happened. The so-called QE3 program has been off the table completely for the better part of a half year! In fully 4 previous FOMC meetings since QE2 ended, including an emergency one, the Fed has steadfastly said no QE3.
So this Tuesday during the FOMC’s 5th post-QE2 policy meeting, for the umpteenth time it again declared economic conditions were far too good to warrant a QE3. Yet for reasons that utterly defy me, and I live and breathe the financial markets all day long every day, currency and commodities traders were surprised by this. Do they live under rocks? Where on earth have they been since the end of June?
Even though there was absolutely zero reason to expect a new quantitative-easing announcement, the US dollar was immediately bid sharply higher. And starting out near highs already, this drove the breakout above its topping range shown above. A stronger dollar along with less monetary inflation than some apparently expected just crushed popular commodities including gold and oil. It was a bloodbath.
Thus the flagship CCI plunged to fresh-new correction lows. Its total correction extended from an already-outsized 18.3% in early October to 20.6% this week. Having actively traded this commodities bull since its very beginning, to me this looked and felt like a desperate capitulation. Plunging commodities were driven to their most-oversold levels since the stock panic, which are clearly unsustainable.
The key to this entire commodities correction continues to be the fortunes of the US dollar. The world is not consuming less oil, nor producing more gold, than it was back in April near that all-time CCI high. Global commodities demand growth continues to outpace supply growth. The only material thing that changed was the value of the US dollar in the global marketplace. Can this safe-haven currency keep on rallying?
This next secular chart offers some insights into this critical question. Running from 2001, it encompasses the entire secular commodities bull and secular US-dollar bear. Commodities prices have been rising on balance, and the US dollar falling on balance, for good fundamental reasons over this long span. Secular trends rarely change, and only when fundamentals do a radical turn-one-eight.
These inverse supply-and-demand-driven secular trends remained pretty steady until the epic disruptions of 2008’s wild stock panic. The most extreme fear we will ever see in our lifetimes led to a deluge of capital fleeing the stock markets and commodities to temporarily weather the storm in cash and Treasuries. This drove the biggest and fastest USDX rally in history over such a short span, the dollar rocketed 22.6% higher in just 4 months!
Back then, just like today, there were widespread fears about whether or not the euro would survive. Believe it or not, they have flared up periodically ever since this composite currency was born in January 1999. Yet the euro keeps chugging along and Europe gradually gets more and more integrated. There was even a full-blown euro panic in the spring of 2010, yet the euro is alive and well and higher today.
Despite all the extreme-dollar-bullishness (and extreme-euro-bearishness) hype in late 2008 and early 2009, the USDX couldn’t continue higher once its panic buying abated. Why? Because its fundamentals are utterly rotten! The Fed continues to create vast new supplies of fiat US dollars out of thin air every year, yet a world awash in depreciating dollars is demanding fewer as it diversifies away from them.
Perpetually-higher dollar supplies coupled with waning global dollar demand equals lower dollar prices, there is no other long-term economic outcome possible. Sure, demand can spike from time to time as stock-market selloffs or Europe fears drive temporary flight-capital rushes. But once the intense fear passes, and it always does, the fundamentally-bearish US dollar continues to drift sideways to lower. The Fed simply prints too many new dollars for global demand to ever keep up with.
Since that epic fear-driven dollar spike during the stock panic, the US dollar has largely been grinding along sideways. This sorry consolidation isn’t much above the USDX’s all-time low carved in April 2008. If the dollar is as fundamentally bullish as traders argue today, why on earth hasn’t it gained an inch of ground since the stock panic? Because the supply-and-demand fundamentals of this rapidly-inflating currency are still bearish!
In contrast consider commodities. The panic’s dollar rally drove a brutal 46.7% plummeting of the CCI, utterly unprecedented. Bearish analysts came out of the woodwork, including many commodities stars prominent today, utterly certain the secular commodities bull was over. Just look at the charts, they reasoned. The technical damage was so apocalyptic that there was no way the commodities bull could be anything but dead.
But the legions of commodities naysayers then were dead wrong, the secular commodities bull resumed immediately after the excessive fear started abating in early 2009. The CCI extended its old pre-panic ways of powering higher on balance with little interruption, blasting to new all-time highs in late 2010 and early 2011. And the weaker the dollar was, the faster commodities surged. Just like in the old pre-panic days.
How could commodities continue rallying so dramatically after being nearly cut in half? Simple, their underlying global supply-and-demand fundamentals remained bullish. We live in an industrialising world where billions of people are working tirelessly to raise their families’ standards of living. This ups consumption and hence commodities demand, and there is no way scarce supplies can keep up.
Regarding the state of commodities and the dollar today, there are really only two questions to consider. Will global dollar demand, even after this latest Europe scare inevitably fades, continue to grow faster than the Fed’s endless supply growth? Remember that the world is drowning in dollars, and central banks have spent a decade trying to diversify away from their depreciating dollar-dominated portfolios.
And will worldwide commodities supplies suddenly miraculously start growing so fast that they outpace voracious global demand for the first time in a decade? I think the most logical answer in both cases is no. The Fed will continue to create endless new dollars out of thin air, increasingly necessary to monetise Obama’s unprecedented national-debt growth, far faster than the rest of the world will want to buy this paper.
And hard-working Asians, Americans, and even Europeans are not going to stop striving to increase their families’ standards of living simply because Europe’s bloated socialist governments are too large to sustain. Even after a decade of relentlessly-rallying prices, the world still cannot produce enough commodities to fully offset the surging global demand. The dollar is bearish, commodities are bullish.
Even from a pure short-term technical and sentimental perspective, the USDX and CCI are due for an imminent turn. The dollar is overbought today by its own bear-to-date standards, while commodities are wildly oversold by their own bull-to-date ones. Sentiment is nearly euphoric on the dollar, and nearly terrified on commodities. Traders expect the currency to soar forever while commodities keep plunging.
If you have even a single contrarian bone in your body, you have to love this setup! When everyone thinks something is heading higher indefinitely, that means the top is in and its rally is over. When everyone thinks something is going to spiral lower forever, there is no clearer sign the bottom is in and a major rally is due. The smart contrarian play is to short the overbought currency and buy the oversold raw materials, without any doubt.
The bottom line is commodities have been crushed by the surging US dollar. This sharp dollar rally, amplified by unsustainable Europe fears, is the reason this latest commodities correction has been so long and deep. But this doesn’t change the underlying fundamentals for the raw materials or the currency, which remain bullish and bearish respectively.
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