On any
day that commodities prices move materially, the financial media is quick to
ascribe their action to the US dollar. And this oft-discussed causal
relationship is certainly logical. With commodities priced in dollars, a
stronger dollar will buy more units of any given commodity while a weaker
dollar buys less.
But
countless times as I've seen CNBC reporting on this important relationship,
I've gotten the impression that the talking heads think the US dollar is the
primary or only driver of commodities prices. Neither is true of course. Each
commodity has its own unique global supply-and-demand profile, the true
fundamentals that drive its price. Nevertheless, the fortunes of the US
dollar are often a significant secondary driver.
The
long-term data readily reveals the secondary nature of the dollar's role in
commodities prices. During its secular bear between July 2001 and April 2008,
the key US Dollar Index (USDX) lost a staggering 41% of its value! And if the
dollar was the main driver of commodities prices they shouldn't have rallied
significantly more than the 40% weaker currency demanded. Yet between October
2001 and July 2008, the Continuous Commodity Index (CCI) soared 235%. Supply
and demand far outweighed the dollar!
Still,
the US dollar has a disproportionate impact on commodities-trader psychology.
The all-important worldwide supply-and-demand data for most commodities is
usually merely estimated, is released piecemeal in a haphazard fashion on
differing schedules by many unrelated organizations, and is very difficult to
synthesize into a tradable whole. Meanwhile, the dollar's levels are always
available in real-time. Thus it is far easier watching the dollar to game
commodities rather than delving into their fundamentals.
And with
the recent stock panic driving the most extreme market psychology we'll see
in our lifetimes, the dollar's psychological impact on commodities has
temporarily ballooned to monstrous proportions. A panic is a bubble in fear,
and fear drives highly emotional trading that is totally divorced from
underlying fundamental realities. The dollar's extreme fear-driven panic
behavior, despite being irrational, really drove an unprecedented commodities
bloodbath. The carnage was truly epic in scope.
Even
today, 5 months after the stock panic gave up its ghost, we are still dealing
with the commodities aftermath spawned by the dollar's behavior within the
panic. While extreme market episodes are traumatic, extreme opportunities emerge
out of them. Today we are seeing a young commodities trend just starting to
unfold, a recovery from the irrational panic prices, that will ultimately
lead to massive profits.
To
understand why, we first need to gain perspective on what actually happened
with the dollar and commodities during the stock panic. I am using the
industry-standard USDX to represent the former and the venerable CCI for the
latter. The USDX is a trade-weighted basket of the US dollar versus other
major currencies. And the CCI is a broad geometrically-averaged index that
tracks the prices of 17 equally-weighted major commodities. They are the best
measures available today of the US dollar and commodities in general.
In early
July 2008, the CCI hit a bull high. Commodities were doing fantastically
well, as you probably remember thanks to the endless attention the media gave
oil in the $140s last summer. But with so much capital flooding into
commodities, they were definitely getting overbought. As in all secular
bulls, a CCI correction was expected and inevitable to bleed off the greed
and return prices to more reasonable levels.
This
correction started in early July and was quite steep. In its initial 3 weeks
alone, the CCI plunged 11.7%. It was the biggest
and fastest correction of this commodities bull, which was
fitting considering the biggest and fastest upleg led to it. During that
initial correction, the USDX was dead flat. In fact on July 15th after the
CCI had already fallen 4.6%, the USDX ground down to close within 0.5% of its
all-time low achieved just 3 months earlier in April. The dollar's
fundamentals were horrible, as its price reflected.
Normal
corrections in ongoing secular bulls usually end at or just under their 200-day
moving averages. And in most of August the CCI's 200dma,
despite being inflated from the massive preceding upleg, looked like it would
hold. But then some of the most peculiar events in all of market history
started to unfold which radically altered the course of commodities from
normal bull-market correction to something far worse.
While the
stock panic didn't formally start until early October when the VXO
implied-volatility fear gauge rocketed over 50 and stayed there, the bond
panic began much earlier. Back in July, the giant GSEs Fannie Mae and Freddie
Mac teetered on the verge of insolvency. Large investors worldwide,
institutions and governments, feared their GSE bonds were getting much too
risky. So they started selling GSEs and flooding into US Treasuries, long
considered the least-risky bonds in the world.
With the
massive American mortgage-securitization market imploding, foreign investors
worried about the fallout in their local mortgage markets. They sold local
mortgage-backed bonds and also wanted to park their capital in Treasuries to
weather the storm. But before buying US Treasuries, they had to buy US
dollars first. So the USDX surged 5.6% in August. For the usually
glacially-slow currency markets, this was a stupendous spike higher.
Of course
futures traders saw this incredible dollar action, and wrongly assumed it was
fundamental. Dollar bulls argued aggressively that the dollar was rallying
because it was a great currency and things were worse in the rest of the
world, particularly Europe (the euro is 58% of the USDX's weight). And if
this was fundamentally true, commodities prices would probably decline on the
dollar strength. So futures guys sold. Unfortunately this happened right
above the CCI 500 level where the correction probably would have ended
without the bond panic.
When this
dollar-safe-haven bond trade started to unwind in September, commodities
rallied rapidly. But no one knew that the first full-blown stock panic in
101 years loomed right around the corner. After the
stock markets sold off sharply into mid-September, the USDX started surging
again. Stock traders around the world were getting scared, so they dumped
everything. And many wanted to park this capital in US Treasuries even though
their yields were terribly low. At least they wouldn't lose their capital in
Treasuries.
But in
order to buy safe-haven Treasuries, once again the foreign investors had to
first buy US dollars. So the USDX again surged to new rally highs, and again
the Wall Street consensus declared this was fundamentally righteous rather
than a fleeting fear-driven anomaly. Futures traders saw the continuing
amazing dollar strength so they accelerated their commodities selling. This
was compounded by the general desire to flee risky assets of all kinds,
including commodities, regardless of their fundamentals.
By the
time the dust settled in late November, the USDX had rocketed 22.6% higher in
just over 4 months! This rally was mindboggling. It was easily the biggest
move the USDX has ever made over such a short span in this index's entire
history! And that goes all the way back to 1971 and includes
the legendary dollar bull of the early 1980s! Nothing like that autumn 2008
dollar rally had ever happened before.
With
commodities traders already scared anyway, as nearly everyone was terrified
in the panic, the mighty dollar rally was a great excuse to sell. Over the
rough span of this fear-driven dollar super-rally, the CCI lost 46.7% of its
value. This index too is generally slow to move due to its construction
(geometric averaging), so this large of swing was unprecedented. Not even over
the entire duration of the Great Depression did commodities prices
fall as far as they did in just 5 short months last year! It was a bloodbath.
Looking
at the chart above, technically about 4/10ths of the CCI's correction was
probably righteous and driven by overbought conditions in early July. But
when the bond panic followed by the stock panic slammed into commodities just
when they were trying to bottom, these titanic forces contributed to the
other 6/10ths of the CCI's total loss. The fear-driven dollar buying
slaughtered commodities.
Global
commodities fundamentals prior to the panic probably justified the 500 to 525
CCI levels we saw in August after the expected and healthy commodities
correction. But realize it was the flight capital deluging into the US dollar
that drove the CCI down under 350, not imploding fundamentals. Commodities
fundamentals evolve very slowly, over many years, and couldn't possibly
change fast enough to justify such a massive move in such a short period of
time. It was sentiment-driven.
Technically
it is crystal clear the unprecedented dollar rally is what drove the lion's
share of commodities' unprecedented decline. Note above the giant X formed
between the USDX and CCI last year. Their overall inverse correlation over
this panic timeframe is nearly perfect. The dollar was indeed the primary
driver of commodities prices over this peculiar span of time. The talking
heads were right in this case.
With the
dollar exerting such great psychological influence over commodity prices during
the panic, the dollar could continue to have an outsized (yet moderating)
effect on where commodities are heading from here. Actually we are already
seeing some of this moderation in the USDX and CCI behavior since the panic. This
next chart zooms in to the past 6 months or so and offers insights into this
evolving inverse correlation.
Since
bottoming in early December, the CCI has actually been carving a nice post-panic
uptrend despite the USDX largely remaining up in the 80s near its
panic-climax levels. Commodities' higher lows and higher highs have led to a
23.4% gain in the CCI as of this week. But while the dollar's fear-driven
influence on commodities prices is gradually waning, it is still a key factor
in their short-term performance.
The CCI's
initial rebound out of its panic lows in early December was driven by a USDX
plunge. And in February the CCI fell sharply on USDX strength, although
commodities remained in their uptrend. Provocatively the CCI's lows in late
February and early March matched the dollar's highs almost perfectly. When
the stock markets sold off again into early March, this panic aftershock
ramped futures traders' fears and they reverted back to their
sell-commodities-buy-dollars trade from the panic.
But still
the CCI largely held near support despite the dollar strength in early March,
evidence the latter's influence is waning a bit from its panic heights. In
mid-March the goofy US Fed announced it was going to start monetizing $1750b
of debt, including $300b in Treasuries. When investors buy bonds, they
have to pay with cash. But when central banks buy their own sovereign bonds,
they create this cash out of thin air. Thus this monetization is pure
inflation, evidence the Fed is going to trash its currency. The dollar
plummeted.
The 2.9%
plunge in the USDX that day was the third largest daily selloff in this
index's entire history. The first was in 1973 and the second in 1985, so the
Fed's inflationism drove the biggest dollar selloff in nearly a quarter
century! Naturally on such a gigantic down day, the futures guys rushed in to
buy commodities. The CCI surged and was back up to resistance in a matter of
days. That was a fun rally to ride, and one of the reasons commodities stocks
have been the best-performing sector since the March stock-market lows.
After
that both the CCI and USDX largely flatlined in late March and April,
consolidating as traders got comfortable with their new levels. But starting
in late April, the CCI surged again. Interestingly this rally initially
emerged when the dollar was fairly flat. The causality was subtly shifting,
currency traders started selling the dollar because commodities were strong
instead of the other way around as usual.
These
latest CCI and USDX moves have important technical implications, as both
indexes have finally crossed their 200dmas again. For commodities, seeing the
CCI move back above its 200dma is very bullish. In secular bulls, the 200dma
is often the strongest long-term support. But for the dollar, seeing its
200dma fail is very bearish. In secular bears, the 200dma is often the
strongest long-term resistance. These key 200dma crosses will encourage
technically-oriented traders to continue buying commodities and selling the
dollar.
So since
the panic ended, the CCI's behavior has already greatly improved technically.
While the USDX fell to its lowest levels of 2009 this week, it was still
merely back to mid-December levels where the CCI struggled near 350. Yet
today despite similar dollar levels the CCI is hovering around 400. This not
only shows that the dollar's outsized panic influence is moderating, but that
commodities fundamentals never justified their ridiculously low prices seen
in the panic.
With the
epic dollar strength driving the commodities selloff during the panic, it is
interesting to consider what drove the dollar itself. The answer is
the daily trading action in the US stock markets! It blew my mind throughout
the panic that dollar bulls were claiming the dollar's fundamentals were
improving, yet the dollar was generally only rising when the S&P 500
(SPX) was falling. Stock fear fueled the dollar rally!
Out of
the many thousands of charts I've built as a student of the markets, this
USDX versus SPX one across the panic is one of the most stunning. Since the
stock panic ignited, the USDX's behavior has been a mirror image of
the SPX's! The aggressive dollar buying wasn't because it was fundamentally
better than the euro, but simply because stock investors were terrified and
desperately sought dollars and Treasuries as a temporary safe haven.
The
general symmetry of this relationship is very striking, the dollar was only
strong while the SPX was weak and vice versa. The only times the USDX hit new
highs over this entire span was when stocks were falling to new lows. And
this panic relationship is not just skin deep, but actually very precise
technically.
In
October, the first month of the stock panic where the SPX plummeted 27.1% in
less than 4 weeks, no fewer than 5 of the days that the USDX made new rally
highs happened on the very days where the SPX made new bear lows. On October
27th when the SPX initially bottomed at 849, the USDX topped that very day. The
dollar wouldn't make any new highs until the SPX again started falling. Stock
flight capital, not fundamentals, was driving the dollar buying.
In
November this behavior continued. The USDX hit new highs on the only 2 days
where the SPX hit new panic lows. And the only other days that month where
the USDX hit new highs happened to be ones where the SPX was very weak and
slashing through key technical levels on its way to lows. And then when the
SPX bottomed again at 752 on November 20th, the USDX magically topped that
very day. It wouldn't see another new high until the end of February when the
SPX first decisively closed at a new low under November's.
In late
February and early March, the only days the USDX made new rally highs was
when the SPX hit new panic lows. This happened 5 times! And on the days when
the SPX rallied within this span, the USDX sold off. Honestly this
relationship could not have been any more precise and clear. The dollar
buying, throughout the entire panic, was a direct response to stock-market
weakness. So indirectly via its USDX impact, the stock panic affected
commodities on a mirror-like day-by-day basis.
Of course
since the SPX started rallying out of its final
bear bottom in early March, the dollar has sold off
considerably. Capital that was hiding in dollars and Treasuries is leaving,
unwinding this anomalous trade. The dollar wasn't suddenly fundamentally
sound as Wall Street argued, it was just a convenient refuge in a storm. Given
this abnormally tight inverse relationship between the USDX and SPX,
commodities' near-term potential could still be heavily influenced by
stock-market performance going forward.
Back in
early January when fears ran high, I did some fascinating research on
stock-market history. Thanks to the panic, 2008 was one of the worst
stock-market years ever. But it turns out in history that the best stock
market years immediately follow the worst. That must-read
essay I wrote 4 months ago explained why in depth. The
parallel unwinding of extreme fear and extreme-low-price anomalies leads to huge
post-panic gains.
Its
controversial conclusion, which I still believe today, was that 2009 should
be a massive up year. We are talking 25% up to maybe even 50% in the S&P
500! And considering the SPX started 2009 near 900, such levels would be much
higher from here. If this history holds, which it should, the stock
markets will rally on balance for much of the rest of this year. And that
means the dollar-safe-haven trade will continue to unwind. Stronger stock
markets help portend a weaker dollar, much like we saw between early 2003 and
late 2007.
The
dollar's fundamentals also point to lower levels. In a time when investors
and central banks around the world are trying to divest dollars, the Fed is
printing new ones at record rates. Over the past year, the Fed has grown the US monetary base by a scandalous 111.0%! Big
inflation is coming, there is no doubt. A multiplying
dollar supply coupled with waning global demand ensures that lower dollar
levels are inevitable. Of course a weaker dollar is especially bullish
for gold, the ultimate anti-dollar play.
At Zeal
we've been telling our newsletter subscribers about the great
opportunities the anomalous dollar rally was creating in commodities since
the very heart of the panic. We've been aggressively buying elite commodities
stocks ever since, and our unrealized profits are getting pretty hefty. Nevertheless,
this commodities run is young and probably just getting started. Subscribe today and get
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again prices will blast higher.
The
bottom line is most of last autumn's epic commodities selloff was driven by
the biggest and fastest US dollar rally ever witnessed. And it was
stock-panic fear, not fundamentals, that drove both the dollar buying and
resulting commodities selling. Because of this anomaly, the dollar remains
overpriced while commodities remain far too cheap relative to their
underlying global supply-and-demand fundamentals.
As fear
from the stock panic continues to fade, the flight-capital dollar trade will
continue to unwind. The resulting lower dollar will be very bullish for
commodities, primarily because it will get futures traders buying again. In
the wake of their sharp panic interruptions, the dollar's secular bear and
commodities' secular bull will continue. And in commodities' case, there is
still much catching up that needs to be done.
Adam Hamilton, CPA
Zealllc.com
May 22, 2009
Read
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