The Dollar, Commodity Currencies and Commodity Prices

The dollar embarked on a massive rally starting in May 2014 when the dollar index futures contract rose from 78.93 to 100.38 in May 2015. The ten-month increase in the value of the U.S. currency was unusual as an over 27% move in major world exchange rate is a huge adjustment in value. The dollar moved higher as the U.S. economy recovered from the effects of the 2008 financial crisis. The Federal Reserve applied monetary tools to stimulate the U.S. economy following the crisis.

Quantitative easing (QE), inflated the central bank’s balance sheet by purchasing debt instruments to keep interest rates low. The Fed cut short-term interest rates in the U.S. to zero in the years following the crisis. The theory behind QE and low short-term rates was that they would provide economic stimulus by inhibiting saving and encouraging borrowing and spending.

As the monetary policies appeared to achieve their goals in 2014, the dollar moved higher as the central bank ended QE and signaled that interest rate hikes would lift the Fed Funds rate off the zero interest rate level. The prospects for higher U.S. interest rates caused the dollar to strengthen. In December 2015, the Federal Reserve increased short-term interest rates for the first time in nine years and promised 3-4 more increases in 2016. The dollar moved higher and commodities lower.

The prices of commodities moved lower

Commodity prices are highly sensitive to the dollar and interest rates. The low dollar and historically low interest rates following the financial crisis in 2008 caused many raw materials to rise to all-time highs. The price of gold rose to over $1900 per ounce in 2011 and silver traded to just below $50 per ounce.

Many other commodities posted all-time peaks in 2011 and 2012. However, despite the zero interest rate environment and a weak dollar, the economic slowdown in China and less demand for raw materials from other areas of the world caused commodity prices to begin to fall. When the dollar rally commenced in 2014, it added fuel to the bearish fire in commodities they picked up downside steam. The dollar hit highs in 2015, and many commodity prices traded to multiyear lows in late 2015 and 2016. As an example, crude oil sold at the lowest price since 2003 on February 11, 2016, when it hit $26.05 per barrel on the active month NYMEX crude oil futures contract. Sugar hit lows of just over 10 cents per pound in August 2015 and gold traded to lows of $1046 per ounce at the end of 2015. The rise in the dollar caused the price of raw materials across all sectors to fall.

Commodity currencies followed

Mineral rich nations depend on revenue from raw material sales and the bear market in commodities had an adverse impact on their currencies. At the height of the commodity rally, it took U.S. $1.10 to purchase one Australian dollar. When commodity prices hit bottom in late 2015 and early 2016, the value of the Australian currency had plunged to an exchange rate of around 68 U.S. cents to the Australian dollar.

The Canadian dollar, another commodity-sensitive currency moved from over U.S. $1.06 in 2011 to just over 68 cents in early 2016. The currencies of other nations that depend on their natural resource reserves and commodity production moved lower. The Brazilian real and Russian ruble both plunged alongside commodity prices.

In 2016, weak economic growth in the U.S. during the first quarter and fears of contagion from weak economies around the world caused the Fed to pause its interest rate hikes. Through May 2016, the Fed did not move to increase the Fed Funds rate and keep their December 2015 promise to markets.

A correction in 2016

The lack of further U.S. interest rate hikes caused the dollar to correct lower over the first five months of 2016. The dollar index fell to lows of 91.88 on May 3.

In response, many commodity prices recovered. Crude oil moved from $26.05, the February 2016 lows to over $50 per barrel by late May – an increase of over 92% in less than four months. The prices of many other commodities rallied, and commodity currencies moved higher. The Australian dollar recovered to just above 78 cents on the U.S. dollar, and the Canadian currency advanced to over 78 cents. The Brazilian real and Russian ruble also moved higher again the U.S. dollar in sympathy with higher commodity prices.

The lack of another interest rate hike by the U.S. central bank over the first months of 2016 proved bearish for the dollar and bullish for commodities and commodity currencies. However, when the Fed released the minutes of the April Federal Open Market Committee Meeting on May 18, the markets translated the discussions as an indication that the Fed would increase rates once again during the summer of 2016. An immediate rally in the dollar ensued, and many commodity prices and commodity-based currencies moved lower. Since the dollar traded to new lows in May and then rallied sharply, it set up a significant technical pattern on the long-term chart that could propel the dollar higher and commodities and commodity-sensitive currencies lower in the months ahead.

A bullish key-reversal trading pattern in May 2016

A bullish key-reversal trading pattern on a monthly chart occurs when a market price falls to a level below the previous month’s low and then closes the month above the last month’s high price. The U.S. dollar experienced this price pattern in May 2016. The dollar index futures contract traded to lows of 91.88 during May; the low in April was 92.975. The high in April was 95.21, below the ending price for the dollar index on Tuesday, May 31 resulting in the bullish technical signal on the long-term monthly chart.

The last bullish key-reversal trading pattern in the dollar index happened in October 2015 when the index closed at 97.005. The bullish technical signal caused a rally to highs of 100.60 by December 2015 – an increase of 3.7% from the October closing price. Another such technical pattern in the dollar occurred in July 2014. The dollar index closed that month at 81.53 and rallied to 100.38 by March 2015 – an increase of 23% in eight months, the bulk of the recent move for the dollar. Each month between July 2014 and March 2015 the dollar rose in value.

The technical signal for the dollar in May was a highly significant event. It could have grave consequences for commodity prices and commodity-sensitive currencies in the months ahead. This technical pattern on the monthly chart in May 2016 is flashing a danger sign for commodities and commodity currencies which have recovered over recent months. However, a weak employment report in late May caused the dollar to retreat once again causing the prices of some staples to move higher in early June. Markets, across all asset classes, have seen increasing volatility. Since the commodity markets tend to be the most volatile of all asset classes, a continuation of wide price swings is likely to dominate market action throughout the balance of 2016.