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Commodities And The Dollar: Strange Bedfellows – Seeking Alpha

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One of the more reliable inverse correlations in the markets is that of the dollar vs. commodity prices. We generally get strong dollar inflows when there is a flight to safety in the markets, which typically happens when there is a weak global economy. When the global economy is weak, so are commodity prices and vice versa. This is illustrated by the CRB Commodity Index and the U.S. Dollar Index in the chart below.

United States Dollar versus Commodities Research Bureau Commodity Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Furthermore, many commodities are hard assets. A weak dollar environment simply means that there are more dollars to go around for a finite supply of hard assets. So far, 2017 has been a head scratcher – as if someone had flipped a switch in the dollar/commodity inverse correlation. In 2017 there has been a positive correlation, meaning a weak dollar has accompanied weak commodity prices, so what gives?

In part, the answer is geopolitical. Since the euro comprises 57.6% of the U.S. Dollar Index, the trend of pro-EU election victories in The Netherlands and France, and possibly one coming in September in Germany, has lit a fire under the euro. If Angela Merkel wins in September, the euro could go higher.

In 2016, things looked dire for the EU – due to the 1-2 punch of Brexit and the Trump election victory – making the relief rally in Europe’s common currency in 2017 understandable. Still, Europe has many problems that are difficult to solve, like a common monetary policy but not a common fiscal policy, so the euro’s structural issues are still there. In some respects, the eurozone crisis, starting in 2010, never ended.

United States Dollar and Euro Exchange Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

So, if the U.S. Dollar Index is down because of a strong euro, why are commodity prices weak?

China’s Role in the Commodity Price Collapse

Since China is the largest consumer of most industrial commodities, every time I see weakness in hard assets or energy commodities I think of mainland China’s long overdue hard economic landing that is mysteriously being postponed by some very aggressive Chinese government measures.

Commodities Research Bureau Index versus China Foreign Exchange Reserves Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The slide in the CRB Commodity Index started when the Chinese economy began to slow down in late 2014 and we began to witness a massive flight of capital, which so far is close to $1 trillion. The peculiar part is that in 2017 the Chinese government has stabilized the yuan’s exchange rate to the U.S. dollar and halted reserve outflows (so as to curry favor with President Trump), yet commodity prices remain weak.

Chinese Yuan Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For the moment, China has enough money to stabilize the exchange rate, but I don’t think they can keep the present exchange rate situation ad infinitum. Ultimately, I still believe they are headed for a hard economic landing courtesy of their epic credit bubble. When that hard landing arrives, I think they will opt for a “hard” (overnight) yuan devaluation to the tune of 20% to 40%, just like they did in December 1993 under similar circumstances when they devalued by 34%.

I’ve said all this before. In fact, my numerous musings on China in this column were described by one of my colleagues a couple of weeks ago as “that China rant.” That it may be, but the deflationary tsunami that will result from a Chinese economic hard landing will become front page news. . .

What strikes me as peculiar about the Chinese situation is how their economic unravelling moves in fits and starts. Typically, when we see explosive economic growth driven by explosive credit growth such fits and starts are not common. Historically, when the economy rolls over after the credit cycle peaks, the debt overhang tends to push the economy into a nasty recession and we get a deleveraging cycle.

In this case, the Chinese economy has grown 12-fold since the turn of the century, while total credit in the economy has grown by 40- to 50-fold. In other words, total debt to GDP in the economy has grown from about 100% in the year 2000 to over 400% at present if one counts the infamous shadow banking system.

China Total Social Financing versus China Gross Domestic Product Growth Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As China’s economy has slowed, its total social financing has ballooned. Originally, credit growth was pushed into high gear by Chinese authorities in order to stabilize the economy after 2008. However, credit growth in the past five years is acting like a runaway train, with ever-diminishing contribution to GDP and larger amounts being borrowed. I have to point out that shadow banking leverage (unregulated lending), which has exploded in the past five years, is not included in the total social financing indicator. That means total credit in the Chinese economy is much higher than what total social financing indicates.

To use an oversimplified example, the Chinese economy is like a binge-spending consumer living large on credit cards before the bills come due. I don’t know if China will have its own “2008” crisis, but a repeat of the Asian Crisis of 1997-1998 can happen anytime. At the onset of the 1997 crisis, China’s GDP was $961 billion while the 2017 Chinese GDP is estimated to be $12.6 trillion, or 13 times larger.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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