WEAK INFLATION ISN'T TRANSITORY -- COMMODITY PRICES HAVE BEEN FALLING FOR A DECADE -- A RISING DOLLAR IS ONE REASON WHY -- STOCKS REACT BADLY TO LESS DOVISH FED -- RISING BOND YIELDS BOOST THE DOLLAR -- CRUDE OIL LEADS COMMODITIES LOWER
COMMODITIES HAVE BEEN FALLING FOR A DECADE ... Yesterday's message suggested that weaker commodity prices should provide some comfort to the Fed since subdued inflation would allow the Fed to keep rates on hold and prolong the decade-long economic recovery. It turns out the Fed is more worried than comforted about persistently low inflation (as are stock traders); although it waved off calls to lower rates to boost inflation, at least for now. What struck me the most, however, is the Fed claim the low inflation is "transitory". I remember hearing the same thing from the previous Fed head. The fact is that inflation has been stubbornly low for the past decade. And the most obvious way to show that is by looking at a chart of commodity prices. The monthly bars in Chart 1 shows the Reuters-Jefferies CRB Index of 19 commodities peaking in the middle of 2008 during that year's financial meltdown. After rebounding between 2009 and 2010, it plunged again in 2011 and 2014. Commodity prices lost two-thirds of their value since from their 2008 peak. The decade-long plunge in commodities doesn't look very "transitory".
IS LOW INFLATION GOOD OR BAD... No one seems quite sure what caused prices to fall so far, or what that means to the global economy. Low inflation (or disinflation) can be a good thing. Deflation (falling prices) can be bad. The Fed can fight inflation by raising rates. With rates already historically low, it's less able to fight deflation by lowering rates much further. That's even truer of central bankers in Europe and Japan who still maintain negative interest rates. If a decade of unusually low interest rates (and years of quantitative easing) haven't boosted inflation, what makes them think even lower rates will do the trick? Late stage economic expansions usually produce higher inflation which causes interest rates to rise; which, in turn, ends the expansion (and bull markets). [One benefit of higher rates is that they leave central bankers more room to ease when the next recession hits. Lower rates gives them less ammunition]. Lower inflation could keep the current economic expansion going, since it reduces the need for the Fed to raise rates. But we have much less experience with an aging economic expansion with low inflation (as we do now). Which explains current uncertainty. But we do know one reason for persistently lower commodity prices over the last decade. And that's a rising dollar.
Chart 1
RISING DOLLAR PUSHES COMMODITIES LOWER... Weakness in commodity prices is usually associated with a stronger U.S. dollar. And the next chart confirms that. The weekly bars in Chart 2 overlay the U.S. Dollar Index (green bars) over the CRB Index over the last twenty years. It's obvious that they usually trend in opposite directions. Notice that the 2008 commodity peak concided with a sharp upturn in the dollar that same year (see arrows). The 2011 commodity downturn also saw a sharp upturn in the dollar, as it did again during 2014 (see arrows). Another dollar upturn this year has helped push commodity prices lower. That all seems pretty clear. So a rising U.S. dollar since 2008 appears to be a principal reason for weaker commodity prices. The bigger question, however, may be why the dollar has been so strong. The most obvious reason is that foreign currencies have been so weak.
EURO FALLS WITH COMMODITIES... Chart 3 shows commodity prices and the euro falling together over the last decade. That's because both trend in the opposite direction of the dollar. The same is true of other developed country currencies which have also been in decline. The main reason for lower foreign currencies is that foreign interest rates remain lower than in the states. Which suggests that any deflationary forces that exist in the form of falling commodity prices may be coming more from weaker foreign markets than the U.S. Which is another way of saying that weaker foreign economies remain a threat to the stronger U.S. economy.
Chart 2
Chart 3
TRADERS TAKE SOME PROFITS ON LESS DOVISH FED... Traders were hoping for some hints at a rate cut from the Fed yesterday. They didn't get it, and are doing some selling today. Chart 4 shows the S&P 500 falling for the second day in a row. The fact that the SPX is backing off from last September's peak at 2940 is also of some concern. An important previous peak like that is a logical spot for traders to take some profits. And they're using the Fed's less dovish stance as a reason to do so. In addition, the 14-day RSI (upper box) is backing off from overbought territory above 70; while daily MACD lines (lower box) are turning negative. The lower box also shows that the MACD lines failed to confirm the recent price move to new highs. That's usually a warning of some selling to come. At midday, the SPX is threatening its 20-day average (green line). A close below that first line of defense would signal a likely drop to its 50-day average (blue line). Treasury yields are also bouncing today as bond prices selloff. That's helping to boost the U.S. dollar. Which in turn is weakening commodity prices even further. Oil is dropping sharply along with base and precious metals. Energy and materials stocks are among the day's biggest stock losers as a result.
COMMODITY DROP CONTINUES... Chart 5 shows the Invesco DB Commodity Index (DBC) falling further below both moving averages today. Energy and metals are leading the decline. A bouncing dollar is adding to the selling. Falling commodity prices hint at lower inflation, which is what some stock traders are worried about. Which is why they were betting on a rate cut from the Fed.
(click to view a live version of this chart)
Chart 4
