by Raul de Frutos on DECEMBER 13, 2016
Many of our readers are wondering what’s going on with the U.S. dollar and industrial metals.
The dollar and commodities tend to move in opposite directions. Why, then, is the dollar trading at a 14-year high at the same time as industrial metals are on a tear? For how long can these two continue to move together?
Which is the real bull and which one is just imitating?
The industrial metals ETF in black vs. the U.S. dollar index in green. Source: @StockCharts.com.
To answer these questions we need to look at history. The dollar and industrial metals have risen in tandem since September. Even oil prices are making multiyear highs. But this is not such a strange development.
The dollar-commodities relationship has not been without its temporary periods of decoupling. Over the past two decades there were two major periods in which the dollar and commodities moved up together for a whole year. The last time this happened was in 2005 and the causes were rather similar to what we are seeing now.
The U.S. dollar index (in green) vs commodities (in blue). Source: @StockCharts.com.
Back in 2005, industrial metals were on a tear thanks to China’s increasing appetite for commodities. Today, the main factor driving commodities up is higher-than-expected demand growth, especially from China, while lower than expected supply.
That would normally bring the dollar down, but in 2005 there were a series of factors that made the greenback rise, even in the face of a rising commodity market.
First, the dollar’s role in the temporary break in the dollar-commodity inverse relationship in 2005 was owed to a two-year push of U.S interest rate increases (from June 2004 to June 2006) which lifted U.S short-term interest rates above those in the Eurozone. Currently, the dollar is getting a boost as the Federal Reserve is expected to increase rates while interest rates in Europe are in negative territory.
Another driver of a rising dollar, back in 2005, was a blow to confidence in the European Union and its currency dealt by France’s rejection of a proposed European Union Constitution. Similarly, events like Brexit, a referendum in Italy or the upcoming presidential elections in France are adding tensions about stability in Europe and contributing to an appreciation of the dollar against the Euro.
Finally, also contributing to the dollar’s surge in 2005 was a temporary tax break granted by the Bush administration to U.S. multinational corporations, allowing them to repatriate profits from their overseas subsidiaries. This prompted a surge of inflows into U.S. dollars from euros and, unsurprisingly, the dollar rose against the euro. A very similar case is what new president-elect Donald Trump has proposed: Lowering the corporate income tax rate from 35% to 15% while allowing repatriation of corporate profits held offshore at a one-time tax rate of 10%. These policies, if implemented, will create more demand for dollars so it’s no wonder that investors have already been betting on the dollar since the election’s outcome.
By looking back in history we can relate the current macro factors driving dollar and commodities higher to what happened back in 2005. The dollar-commodity inverse relationship is a strong one but there are periods where they can decouple for some time. This means that there is no reason to be bearish on commodities because the dollar is moving higher and vice versa. These two markets could continue to trend higher in 2017. We will continue to watch them closely to determine which one breaks first but, until then, I’m temporarily bullish on both the dollar and commodities.