LONG-RANGE DOLLAR UPTREND REMAINS INTACT -- LATE CYCLE COMMODITY UPTURN IS UNLIKELY WITH A RISING DOLLAR -- STRONG DOLLAR FAVORS U.S. OVER FOREIGN STOCKS -- ESPECIALLY EMERGING MARKETS
LONG-TERM TREND OF THE DOLLAR IS STILL UP... The direction of the U.S. dollar is important because it influences (or is influenced by) by a lot of other markets. That includes commodities, global interest rates, and global stocks. Dollar direction also influences the relative performance of small cap stocks in the states, and various stock sectors. So let's see which way it's going. The monthly bars in Chart 1 show the US Dollar Index ($USD) in a long-term uptrend that started during 2011 and, more significantly, during 2014. The USD formed a major double bottom between 2008 and 2011 before starting to rise. It started climbing more sharply during 2014 when it hit a four-year high, and eventually reached a fourteen-year high at the end of 2016 before peaking. The USD fell throughout 2017 before rebounding at the start of 2018. Where that bounce started from is especially important. First of all, the dollar found support at a rising trendline drawn under its 2011/2014 lows (green arrows). Secondly, it also found support along the flat trendline drawn over its 2009 and 2010 peaks (red arrows). That's where it needed to find support in order to maintain its long-term uptrend. Previous resistance peaks should become new support levels. That's why the flat trendline turned from red to green during 2014 when the two earlier peaks were exceeded. Although not shown here, the 2017 decline also retraced exactly half of its 2011-2016 rally which can also act as a major support area. The USD recently touched a new 52-week high. If that dollar rally continues, that would be bad news for commodities which are usually hurt by a rising greenback.
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Chart 1
RISING DOLLAR IS BAD FOR COMMODITIES ... One of the most reliable intermarket relationships is the inverse relationship between the U.S. dollar and commodities. In other words, they trend in opposite directions. That can be seen plainly in Chart 2. The dollar rally between 2011 and 2016 produced sharply lower commodity prices. The dollar decline during 2017 helped boost commodity prices. This year's dollar upturn has put commodity prices back on the defensive. The daily bars in Chart 3 show the Reuters/Jefferies CRB Index peaking in May of this year and declining since then. It is currently trading below its 200-day moving average. That drop followed an upturn in the dollar that started during April. If those trends continue, that could call into question one of the late-cycle intermarket rotations that usually takes place in the latter stages of an economic expansion. That is the rotation into commodities and other inflation-sensitive markets. In previous cycles, the inflationary impact of rising commodity prices forced the Fed to raise short-term interest rates enough to slow the economy. That has often led to stock market peaks and recession. A rising dollar may prevent that from happening this time (or at least delay it). That could also cause stocks tied to commodities to continue to underperform. The one exception to that trend this year has been energy shares which have benefited from a 14% increase in energy prices. Stocks tied to industrial and precious metals are deep in the red for the year. Gold shares are especially vulnerable to a rising dollar; while a firm dollar and tensions between the U.S. and China have weakened industrial metals.
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Chart 2
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Chart 3
RISING DOLLAR FAVORS U.S. OVER FOREIGN STOCKS -- ESPECIALLY EMERGING MARKETS ... A rising dollar also favors U.S. stocks over foreign stocks. The black line in Chart 4 plots a ratio of the S&P 500 divided by the Vanguard All-World ex-US ETF (VEU). The green line is the Dollar Index. The chart shows the two lines usually trending in the same direction. A falling dollar during 2017 favored foreign shares (falling black line). A rising dollar this year has favored the US (rising line). A rising dollar takes a bigger toll on emerging markets. The red line in Chart 5 plots a ratio of Emerging Markets iShares (EEM) divided by EAFE iShares (EFA). [EAFE includes foreign developed markets in Europe Australasia and the Far East]. The falling dollar during 2017 gave a boost to emerging markets. This year, however, a rising dollar has caused emerging markets to underperform foreign developed markets by a wide margin. Rising U.S. interest rates have also pulled money from emerging markets and have supported the rising dollar. Which has weakened global commodities that are priced in dollars. And stocks tied to them.
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Chart 4
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Chart 5
DOMESTIC EFFECTS OF RISING DOLLAR ... Dollar direction also effects various parts of the U.S. stock market. The gold line in Chart 6 plots a relative strength ratio of Gold Miners (GDX) divided by the S&P 500 which has been falling all year. That's a direct effect of the rising dollar. The falling brown line is a ratio of the Materials SPDR (XLB) divided by the SPX. It too has underperformed the market this year owing primarily to weakness in aluminum and copper shares. Miners in general have had a bad year. The rising dollar has had something to do with that. Small caps have benefited from a stronger dollar. A rising dollar tends to favor more domestically-oriented small cap stocks over large multinationals that derive a lot of revenue from exports. The S&P 600 Small Cap Index has gained nearly twice as much as the S&P 500 Large Cap Index this year (13% vs. 7%). As I said at the start of this message, dollar direction matters. That's true not only for forex and commodity traders, but for global asset managers as well.
