FALLING COMMODITIES ARE HURTING THE AUSSIE AND CANADIAN DOLLARS -- THAT'S HELPING BOOST THE DOLLAR -- BOND YIELDS AND COMMODITIES ARE LINKED -- AND ARE FALLING TOGETHER -- THAT WARNS OF GLOBAL ECONOMIC WEAKNESS WITH CONTINUED LOW INFLATION
AUSSIE AND CANADIAN DOLLARS ARE TIED TO COMMODITIES...Two major events this past week have highlighted the need to view things from a global perspective. Mr. Powell on Wednesday emphasized that the Fed was lowering its short-term rate to partially offset weakness in foreign markets. President Trump yesterday announced new Chinese tariffs to start on September 1 which pushed stocks and bond yields sharply lower around the world. Crude oil fell near -8% and led a general retreat in commodity markets. Safe haven gold was a big winner along with the Japanese yen (owing to relatively flat Japanese bond yields).
A lot more attention is also being given to foreign currency exchange rates; especially with European currencies hitting new lows, while the Dollar Index hit new highs. Yesterday's morning message showed that a rising dollar pushes commodity price inflation lower. It also showed that falling bond yields in Europe are pulling their currencies lower; as well as Treasury yields. So to understand what's happening "here", we have to also understand what's happening "over there". Today's message will continue to build on that global view of things. Starting with a couple of other foreign currencies.
Yesterday's message focused on the inverse correlation between the U.S. dollar and commodity prices. Today's message will show two foreign currencies that trade in the same direction as commodities -- the Australian and Canadian dollars. They trade in the same direction because both countries are big producers of commodities. Australia is better known for copper and iron ore; while Canada is more closely tied to crude oil. Chart 1 shows that the Aussie and Canadian Dollars usually trend in the same direction. If it weren't for the different colors on the chart, it would be hard to tell them apart. Chart 1 also shows that both currencies tend to rise and fall with the CRB Commodity Index. In fact, both are often called commodity currencies. The boxed area shows all three peaking together during 2008 in the middle of that year's financial crisis. The circled area shows the two currencies peaking together again during 2011 and 2012. That followed a downturn in the CRB Index that started during 2011. A third commodity peak during 2014 led both currencies lower that year (see arrows); and all three continued lower until the end of 2015.
Falling commodities weaken those two currencies which, in turn, helps to support the U.S. dollar. That's another reason why falling commodities usually coincide with a rising U.S. dollar. The Australian Dollar has fallen to the lowest level in three years. That's mainly due to its close trading ties with China which imports most of its commodities. A falling Chinese currency also makes those Australian commodity imports more expensive. That's true of all other commodity imports. Especially from the U.S. with the world's strongest currency. Since China is the world's biggest commodity importer, that's a big negative for those markets.
BOND YIELDS ARE ALSO LINKED TO COMMODITIES...Since bond yields are impacted by inflation, it's reasonable to assume that they're also impacted by the direction of commodity prices. And they usually are. Chart 2 compares the 10-Year Treasury yield (green bars) to the CRB Commodity Index (brown area) over nearly two decades. Their correlation isn't perfect. But the chart shows that they do generally rise and fall together. That's been especially true on the downside. The three circled areas show three instances when bond yields and commodities peaked around the same time -- between 2007 and 2008, during 2011, and again during 2014. In all three cases, both fell together after those peaks. Bonds peaked nearly a year before commodities during 2007 during the early stages of the financial crisis. Commodities didn't peak until the middle of 2008. Both, however, have mostly fallen together since then. The rebound in both since the start of 2016 doesn't appear to show much linkage. But let's take a closer look.
Chart 3 shows a close linkage between the two since the start of 2016. It also shows that turns in commodities often preceded turns in bond yields in the same direction. Commodities turned up first during 2016 (first up arrow) and mid-2017 (second up arrow). Both weakened together during the first half of 2017. Commodity prices, however, peaked before bond yields in the middle of 2018 (see down arrows). Both have fallen sharply since then. Bond yields fell yesterday to the lowest level since 2016. Crude oil had its biggest drop in four years; while the CRB Index is testing its 2019 low. To the extent that falling commodity prices reflect global economic weakenss with low inflation, it's no surprise that bond yields are falling along with them. That's not exactly a vote of confidence in the global economy. One other thing about the dollar. When foreigners buy higher-yielding Treasuries, they have to buy dollars first. That suggests that falling Treasury yields may actually be helping to support the dollar. A strong dollar may also be the price the U.S. has to pay for having the strongest economy in the world.
GLOBAL STOCK DIVERGENCE...Relative weakness in foreign stocks is another potential problem for the U.S. market. And the negative divergence between the two is another potential warning. But that's a story for another message.
