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 deployed ahead of the mainstream investors, because once
they start buying 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.
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