- The historical negative correlation between the U.S. Dollar and commodities dislocated earlier this year.
- Recently, correlations are normalizing, providing insight into oil, grain, and gold markets.
- If the Dollar rallies again, commodities could fall.
The War in Ukraine helped dislodge the historical negative correlation between the U.S. Dollar and commodity prices earlier this year. Instead of selling off when the Dollar was rallying, oil prices surged in lockstep because of the risk of supply disruptions and sticky global demand. Recently, however, we’re seeing a normalization in the relationship between commodity prices and the U.S. Dollar, suggesting investors should keep their eyes on the U.S. Dollar Index ETF (UUP) .
In “The Market Was Out of Whack in 2022, So Time to Reset Your Strategy,” Real Money Pro’s Carley Garner explains:
“In a more normal market, commodities move higher as the dollar weakens and lower as the dollar strengthens. But this year we witnessed a rare phenomenon in which both the dollar and commodities (energy and agricultural, but not precious metals) rallied sharply together. In the case of the energies, over the previous 180 trading days, crude oil and the dollar have settled in the same direction 80% to 90% of the time, this correlation usually behaves in the opposite manner. Over the last 30 trading days, the correlation between the two has shifted to a negative correlation of 80% to 90%, so it has mostly normalized (for now). This is important in that it suggests that, perhaps, the market is moving past the "black swan" events that triggered unusual market behavior.”
The longer-term correlation remains abnormal, but Garner notes that the baskets are acting more like usual over a shorter period. It remains to be seen if this shorter-term return to normalcy is durable, but it’s certainly worth watching if you’re long energy stocks.
The Dollar’s strength has waned lately, with the UUP falling 3.1% since July 15th. Currently, it’s sitting on its up-trending 50-day moving average. West Texas Crude has held up better, though, trading sideways near its 200-day moving average. So, if the ‘normal relationship’ has returned, a rally in the UUP from its 50-DMA should coincide with crude prices rolling over.
Are grain prices in trouble?
If oil slides, it could be bad news for grains.
Back to Garner:
“If the September oil futures can't clear and hold $100 per barrel, it doesn't bode well for the agricultural commodities. In fact, we are expecting any near-term strength in oil to fail somewhere between $97 and $102 per barrel; this would be a hint toward weakness in other commodities.”
The War in Ukraine threatened global grain supplies, especially wheat, because Ukraine and Russia are significant exporters. As a result, grains traded higher with oil, solidifying the positive correlation between these commodities. If this relationship holds up, grains will drop if oil prices fall. The Teucrium Wheat Fund (WEAT) is already trading below its 200-DMA, and the Teucrium Corn Fund (CORN) is sitting right on its 200-DMA.
If oil and grains sell off, it would dovetail with my thinking the late-cycle trade (being long cyclical energy/commodities) is long in the tooth. Commodities do better when inflation is rising than falling, and this week’s inflation data was tamer than expected.
What about Gold?
The dollar’s path from here could also have implications for precious metals, particularly gold.
Back to Garner:
“In a normal market, the correlation between gold and the dollar is sharply negative. As one moves one way, the other is expected to move in the opposite direction. Yet, over the previous 180 trading days, gold and the U.S. dollar index have traded in opposite directions only 20% to 30% of the time. That said, the correlation appears to be normalizing in recent weeks (since the dollar peaked in mid-July). This is because market expectations of higher interest rates have declined to leave the greenback slightly less attractive vs. lower interest rate-bearing currencies such as the euro…Going forward, we expect gold and the dollar to trade sharply inversely. Depending on what the dollar does at critical pivot levels, this could mean a breakout to the upside for gold, or failure at trendline resistance.”
On July 20, I explained Real Money Pro’s Ed Ponsi’s long gold trade. The Dollar drop over the past four weeks has sparked a gold rally past Ponsi’s initial targets. Ponsi’s strategy was to sell one-third at each target and to move up his stops on the remainder.
Today, Ponsi updated investors, writing, “Targets 1 and 2 have been hit. I've raised the stop to $1,795. The final third of this trade will either terminate at $1,825, which would be great, or $1,795, which is still pretty good. Either way, we have a winner.”
The Smart Play
As I noted in July, GLD doesn’t track gold perfectly, so you have to adjust its price to mirror Ponsi’s targets. My remaining target for GLD is $172.84, and you’ll want to increase your stop loss to protect yourself in case the Dollar rallies and gold retreats.
Oil prices are at an inflection point near their long-term trend line. Accordingly, my focus has shifted to recessionary-stage and, to a lesser extent, early-cycle stocks. For remaining energy long exposure, the long Chevron (CVX) and SPDR Energy Select ETF (XLE) trade highlighted last week is working, but consider tightening stop losses on remaining oil and gas stocks in case a decline in oil prices extends to stocks.
As for the Dollar, I’d stay on the sidelines for now. It’s trying to hold its 50-DMA, but its 21-DMA is right above it and trending downward. You can revisit it if it recovers that line; otherwise, given decelerating inflation could mean a slowing rather than accelerating pace of rate hikes in the U.S. versus other countries, ‘watchful waiting’ is best.