We are currently at a very interesting time in history as U.S. interest rates are climbing and the dollar is falling in value against other currencies. Last week, even the Chairman of JP Morgan Chase admitted that the coming months could be a time where markets become a lot more volatile. Aside from hiking rates, the U.S. Federal Reserve has announced their intention to decrease the size of their balance sheet by $50 billion each month. Even though the central bank, in the interest of full disclosure and transparency has provided guidance for the operation that will amount to even more tightening of credit than the hikes in the Fed funds rate, they may get a lot more than they are bargaining for when it comes to price volatility across all asset classes. Jamie Dimon told markets that the unwinding of the Fed balance sheet could create havoc in markets.
With the term of the current Chairperson of the Fed coming to an end in 2018, the next leader of the central bank will need some trading skills to ease out of all of that debt purchased during years of quantitative easing. The likely candidate is Gary Cohn, ex-President of Goldman Sachs and current chief economic advisor to President Trump. Cohn is warming up in the bullpen to take the reins of the Fed from Yellen next year as the job description is about to change and a trader rather than an economist will have the skills necessary to guide the U.S. economy through a period that Dimon characterized as dangerous. “We’ve never had QE like this before, we’ve never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.” The central bank should be ready to go into battle during the period of unwinding the massive balance sheet. Meanwhile, increased variance in markets will mean that historical relationships may diverge. In the world of commodities these days we are witnessing just that as interest rates rise, the dollar falls in value against other currencies, and raw materials are not sure which asset class to follow.
The bearish dollar
As the weekly chart of the dollar index highlights, the dollar traded at its highest level since 2002 in early January when the index traded to 103.815. However, that peak has faded in the rearview mirror of the market as the dollar has spent over six months making lower highs and lower lows. The dollar index was trading at 94.904 on the September futures contract as of the close of business on Monday, July 17 which is 8.6% below the January highs. The next level of technical support for the dollar is at the May 2016 lows at 91.88. Meanwhile, the euro currency has been appreciating against the dollar and was trading at over $1.15 versus the dollar on July 17. Source: CQG
As the chart of the euro versus dollar currency relationship illustrates, the next level of technical resistance for the euro is at $1.16305, the May 2016 highs and then at $1.17180, the August 2015 high. If the euro can surpass these levels, it is likely that we will see the $1.20 level given the current trajectory of the rally that commenced at lows of $1.03675 in December 2016. An exchange rate of $1.20 would cause the dollar index to fall through critical support at 91.88. The dollar has been weak despite an environment of increasing dollar interest rates which is likely a sign of underlying weakness in the U.S. currency.
Rates on the rise
The U.S. Federal Reserve has already hiked the Fed Funds rate twice in 2017, and all signs point to a third 25 basis point increase before the end of this year. The Fed has also told markets that short-term rates could rise three more times in 2018 and they have also indicated that their balance sheet will be trimmed to the tune of $50 billion per month. The Fed has taken a hawkish approach to monetary policy, and while the central bank only controls the short end of the yield curve, longer term rates have been moving higher. Source: CQG
The weekly chart of the U.S. 30-year bond shows that the debt instrument has declined from 177-11 in July 2016 to its current level at 152-20. A recent recovery rally that took the long bond to 157-28 in June failed, and the dollar is currently trading a lot closer to its March 2017 lows at 147-07 than the highs seen in 2016. Interest rates in the U.S. are increasing as the Fed tightens credit from historically low levels seen after the global financial crisis of 2008. The legacy of QE will start rolling off the central bank’s balance sheet, but the hawkish monetary policy has not been enough to support the U.S. currency over recent months. Even though short-term rates remain at negative 40 basis points in Europe and Japan, the dollar has chosen to focus on the potential for an end to accommodation in Europe than the current state of debt and currency markets. Meanwhile, rising interest rates and a falling dollar are sending mixed signals to raw materials markets as they currently are having a difficult time deciding which market to follow.
Commodities are the monkey in the middle
When I was a kid growing up in Brooklyn, New York one of my favorite games was “monkey in the middle”. The game consisted of a group of children standing in a circle and throwing a ball to each other with one kid in the middle trying to intercept the ball that could come from any direction at any time. The kid in the middle was the monkey, and these days, it is the commodities market that is the monkey in the middle trying to interpret the conflicting signals coming from the debt and currency markets.
A weaker dollar is typically bullish for commodities prices as the dollar is the reserve currency of the world and the benchmark pricing mechanism for most raw materials. A lower dollar makes commodities prices fall in other currency terms which tend to lead to increasing global demand. At the same time, rising interest rates increase the cost of carrying inventories which is typically bearish for raw material prices as consumers tend to buy commodities on an as needed basis in a rising rate environment. With the dollar falling and rates moving higher, commodities are the monkeys in the middle these days.
Fundamentals become more important than ever
Without clear direction when it comes to macroeconomic forces from the currency and bond markets, commodities are likely to rely on their supply and demand fundamentals when it comes to the path of least resistance for prices. In the energy, metals, minerals, and agricultural markets, deficits or surpluses are likely to determine price direction as the dollar and rates offer conflicting influences.
We recently witnessed a major correction in grain prices as the wheat, corn, and soybean prices moved to the upside as drought conditions in the Dakotas and Montana caused the price of wheat to rally to the highest level since July 2015. Source: CQG
As the weekly chart of CBOT wheat highlights, the price exploded higher from the $4.50 level in late June 2017 to over $5.50 per bushel in early July on weather concerns. The prices of corn and soybeans briefly followed the ascent of wheat. At the same time, the price of oil recently traded to the lowest level of 2017 when nearby August NYMEX futures fell to $42.05 in the second half of June. Source: CQG
As the weekly chart of NYMEX crude oil futures shows, oil declined to the lowest price since August 2016 as increased shale production in the United States weighed on the price of the energy commodity.
At the same time, silver fell from $17.82 per ounce on June 6 to lows of $15.145 on July 10. Gold declined by 7.3% while silver slipped by 15% over the period. Both gold and silver have since recovered but are nowhere near the early June highs.
Inflation or Deflation- That is the question
The Fed has a target of 2% for the U.S. inflation rate and one of the reasons they offered for increasing rates over recent months has been that inflation was moving towards their target. However, recent price action in commodities markets has caused inflationary concerns to decline, but the Fed continues to pursue a hawkish path. One of the risks facing the U.S. as well as the global economy is the rising chances for deflation or worse yet, stagflation. All of the liquidity that central banks flooded the markets with in the aftermath of 2008 has caused faith in fiat currencies to decline. However, we have yet to see an inflationary backlash from the policies that encouraged spending and borrowing and inhibited saving. Today, inflation or deflation is the biggest problem facing the world’s central banks as they monitor economic data.
Interest rates around the world fell to the lowest levels in history, and even though the Fed has been tightening credit since December 2015, they remain at a very low level of 1.25%. The current environment of a weak dollar and rising rates amounts to a steel cage death match in markets and commodities are likely to continue to be the monkeys in the middle looking for direction from supply and demand as macroeconomic forces are providing conflicting influences on prices. Jamie Dimon warned markets last week about the effects of current central bank policy from a monetary perspective. Later in the week, he offered another even stronger warning for policy makers telling them that political gridlock is standing in the way of needed fiscal stimulus. We are likely to see a continuation of increasing volatility in the world of commodities as economic monetary and fiscal policies continue to provide conflicting signals to the raw material markets. Trading rather than investing is likely to offer optimal results when approaching commodities futures and ETF/ETN markets in the weeks and months ahead. Increasing price variance and divergence from historical norms is the likely result of a complex macro economic picture, and that confusion could become the norm rather than the exception for the rest of 2017 and into 2018.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author always has positions in commodities futures, options, and ETF/ETN products. Those positions tend to change on an intraday basis.