FALLING CONSUMER PRICES MAKE FED'S JOB MORE DIFFICULT -- SO DO FALLING COMMODITY PRICES -- A RISING DOLLAR IS PUSHING COMMODITY PRICES LOWER -- WEAK GERMAN YIELD WEIGHS ON TREASURY YIELD -- DOLLAR INDEX IS ON VERGE OF RESUMING ITS UPTREND
FED NOW FOCUSED ON LOW INFLATION ... Today's announcement that consumer prices in the U.S. fell -0.7 in January, the biggest drop since late 2008 (and the first annual decline since 2009), is going to make the Fed's job harder. [The core CPI, excluding food and energy, rose 0.2%]. In testimony earlier this week, Janet Yellen shifted her emphasis away from the need for higher wages to the need for higher price inflation. Although the Fed is looking for the right opportunity to start boosting short-term rates sometime this year, too low inflation makes that a lot harder to do. Falling commodity prices (especially oil) are a big part of the slide in inflation here and abroad. That's why the direction of commodity prices is taking on more importance. Chart 1 shows the CRB Index having fallen -27% since last July to the lowest level since 2009. The biggest contributor to that drop was a -50% drop in crude oil. All other commodity groups fell as well, just not as much. Livestock prices fell -20%, agricultural prices and industrial metals lost 13%, and precious metals -10%. The deflationary threat from the commodity price drop is one of the reasons that bond yields are falling all over the world. Bond yields in eurozone countries have fallen to the lowest levels on record. Several euro countries have negative rates. The German 5-year yield turned negative this week for the first time in history. Low foreign yields are acting as a weight on U.S. Treasury yields. Foreign countries are weakening their currencies in an attempt to boost growth and inflation. That policy, however, strengthens the U.S. dollar. Since commodities are priced in dollars, the stronger greenback keeps downward pressure on commodity prices.
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Chart 1
RISING DOLLAR HURTS COMMODITIES... One of the most consistent intermarket relationships is the strong tendency for the U.S. dollar to trend in the opposite direction of commodity prices. That's because commodities are quoted in dollars. Chart 2 shows the U.S. Dollar Index (green line) turning up last July to the highest level in more than a decade. The chart also shows the CRB Index (of 19 commodity markets) starting its plunge at the exact point when the dollar turned up at midyear (see arrows). Since midyear, the dollar rose 17% while the CRB lost -26%. The reason for the bigger drop in the CRB Index was oil. The average loss in other commodities closely matches the gain in the dollar. The 60-day correlation coefficient between the two markets since July is -.89, which confirms the negative correlation seen on the chart. All of which makes the direction of the dollar a crucial factor in determining the direction of commodity prices.
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Chart 2
EUROZONE DEFLATION THREAT IS EVEN WORSE... Most of the global deflationary pressure is being felt in the eurozone. [Consumer prices in 15 of the of 19 eurozone countries have turned negative]. As a result, eurozone bond yields have fallen to record lows. The ECB is trying to combat that by aggressive monetary easing. That, however, has pushed the euro to the lowest level in more than a decade. Chart 3 shows the close correlation between the German 10-Year T-note yield (green line) and the Euro (green line). It also shows commodity prices falling along with both. That's because commodity prices are "positively" correlated with the Euro, and lower commodity prices weaken bond yields. ECB policy is pushing eurozone yields lower which weakens the currency which, in turn, boosts the dollar which weakens commodities. That's a hard box to get out of.
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Chart 3
WEAK EURO YIELDS WEIGH ON TREASURIES ... Global bond yields have a high degree of correlation, which means that they generally trend in the same direction. That's one of the factors holding U.S. Treasury yields down. Chart 4 compares the 10-Year T-Note Treasury yield (solid green line) to the 10-Year German T-Note Yield (blue line). As of yesterday, the U.S. 10-year yield was 1.96% versus a German 10-year yield of -.33%. The dotted green line shows the 5-Year Treasury yield at 1.47%. The comparable German 5-year yield is below zero (negative). Although U.S. bond yields are near historically low levels, they're a lot higher than foreign yields, especially in the eurozone. That increases the demand for Treasury bonds which keeps yields from rising. The stronger dollar (resulting from a weak Euro) also increases the appeal of Treasuries. Any hint by the Fed of raising short-term U.S. rates would boost the dollar even further. That would keep commodity prices from rising, and could make the threat of global deflation even worse.
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Chart 4
DOLLAR READY TO RESUME UPTREND ... The dollar appears ready to resume its major uptrend. The green bars in Chart 5 show the Power Shares U.S. Dollar Bullish Fund (UUP) testing the upper line in a "pennant" formation defined by two converging trendlines over the last month. The "pennant" is in effect a small "symmetrical triangle" and is a continuation pattern. In an uptrend, that's bullish. At the same time, the blue bars show the Euro tumbling to the lowest level since January. It's in danger of falling to the lowest level in more than a decade. All other major foreign currencies are down today as well. Commodity traders aren't going to like that.
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Chart 5
RISING DOLLAR NEEDS TO BE HEDGED... Several recent messages have emphasized the need to hedge dollar gains when investing in foreign stocks. Today is a good example of why that's the case. Foreign stocks are having much stronger day than stocks in the U.S. European stocks are rallying, with the Stoxx Europe 600 Index at a new seven-year high. Japanese stocks are up 1% and trading at a new 15-year high. Shanghai stocks are up 2%. But those gains are in local currencies. Dollar based gains are much smaller. The green bars in Chart 6 show the WisdomTree Europe Hedged Equity Fund (HEDJ) climbing nearly 1% to a new multi-year high. At the same time, the blue bars show EMU iShares (EZU) trading lower today (while eurozone stocks are rising]. Today's EZU drop is based entirely on the drop in the Euro. That's why American investors need to be aware of the need to hedge out the negative effects of weaker foreign currencies with vehicles like the HEDJ. That's especially true with the dollar on the verge of resuming its uptrend.
