As Dollar Rises, Commodities Spin Backwards

As Dollar Rises, Commodities Spin Backwards

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commodities

Despite an upsurge in global economic data which includes improved industrial production, consumption figures, and reacceleration of growth from China and India, commodity prices have remained quite weak amidst a rallying U.S. Dollar. They’ve weakened to the point that it has begun to undercut the once accepted notion of a global economic recovery.

CNBC recently reported a soaring U.S. Dollar and downtrodden commodity market. While economic data is backwards looking, the prices are forward looking as traders and investors alter their and buy sell orders in anticipation of future developments. So, while commodity prices are signaling bleak future, stock prices are signaling a much brighter future.

Most countries’ broader indices have rallied spectacularly in the past month, with industrial and transportation stocks leading. The best performers were steel, aluminum, and semiconductors. These are industries that do their best when better economic conditions are anticipated.

This set of conflicting signals is giving many market observers a case of cognitive dissonance. It’s not normal for different asset classes to be signaling such divergent outcomes, after all, if stocks are correct in forecasting an economic rebound, then commodity prices should be catching a bid in anticipation. On the other hand, if commodity weakness is signaling a slowdown, then it doesn’t make sense for these individual, cyclical stocks to be so strong.

There is one perspective that clarifies this divergence. First of all, price action in cyclical stocks has been very strong with the Morgan Stanley Cyclical Index at all-time highs and demonstrating relative strength, but the companies; they are reporting backlogs and raising guidance for future quarters. This proves that, contrary to skeptics, this is not about a bubble in stocks.

Instead, looking at the strength in the US dollar and weakness in the Euro helps clarify the mixed signals. Since most commodities are priced in US dollars, the strength in the dollar automatically pushes down assets priced in dollars. Until cyclical stocks weaken or economic data disappoints, this is how traders should interpret commodity weakness. Additionally to verify this hypothesis, traders should watch how commodities perform in the event of dollar weakness.

There are a few reasons to explain the strength in the US dollar. First is the immediate effect of stopping quantitative easing, whose purpose and intent was to weaken the dollar to make exports more attractive. A longer term driver is the strength of the US economy, which is growing at 2-3% and looks set to raise rates within a year or so, in contrast, European economies are slipping into recession and it is anticipated that the ECB will announce some interventions.

The Euro is falling in anticipation of ECB Chief Mario Draghi announcing Europe’s own liquidity program. Given that the Euro is down so much in such a short period of time, it would not be a surprise at all to see a relief rally after the news is announced, as traders sell into the news. Another factor in the dollar strength has been the geopolitical turmoil. The dollar is considered a “safe” asset. With the geopolitical turmoil with ISIS in Syria and Iraq as well as the continued troubles between Ukraine and Russia, foreign money has flooded into US dollars.

The dollar strength has certainly hurt commodities with a 0.89 inverse correlation between the two assets. Given this, investors and traders should not misinterpret the commodity weakness as negativity regarding global growth. Instead, traders should pay more heed to the strength in commodity producing companies and commodity consuming companies.

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