Commodities, Currencies and Equities

The relationship between currencies, commodities and stocks is a moving target. Since August 24 there has been a very tight correlation between the Shanghai Composite Stock Index and the Commodity Research Bureau (CRB) Index. For once there can be little discussion as to which is leading and which is following. With China consuming so many commodities, the CRB Index is affected if there are signs the Chinese economy is slowing; it declines when Shanghai stocks decline as the presumption is that demand for commodities will slow down.

The interesting point from the currencies perspective is that oil is not so closely linked as the composite index of all commodities. This brings me to another point I have often written about: the correlation between the dollar and oil. In my last commentary I pointed out that this tight correlation was disconnecting due to speculators partially withdrawing from the market. This relationship is a common occurrence in the market, especially in the past two years. As investors mature in the asset class they fine-tune their focus in an effort to be one step ahead of the market and make more money.

Where investors/speculators used to trade the CRB Index in the same way you could trade a Dow index fund, they now trade oil or metals and precious metals and soft (agricultural) commodities because these components often move in different directions on the same day's trading. The CRB Index is not an efficient method to maximize profits. Just as the Dow is a market of individual stocks making up a stock market, the CRB Index is a market of commodities making up a commodity market. Of course, participants in these markets have been trading soy beans, lumber, gold and oil individually for years, normally hedging their natural business. However, what has changed is the influence and the massive jump in the amount of business in these component markets that is driven by investor/speculator participants. This has come about as the financial crisis led these participants to seek out other asset classes as investments after credit and stock markets became so uncertain. This new participation led to last year's run up in oil as the largest speculators came to the realization they could almost control the market in the same way the Hunt brothers tried but failed to corner the silver market in 1979. The big difference was that in 1979 they did not have the interconnected global financial markets of today.

To get back on the subject, Monday showed just how disconnected the oil-dollar relationship has become. Oil fell $3.40 per barrel, while the euro rose one cent and the pound rose nearly one and a half cents. In the height of last year's speculation, the currency to oil correlation was so close it could be defined that a $5 rise in oil was equal to a 1 cent rise in the euro. The reason turned out to be that the speculators bought oil in an effort to make more money by also buying the euro. The market believed in the idea of a relationship and it became a self-fulfilling prophecy, just as when a prominent technical analyst calls the top or bottom of a market and everyone follows his observation by either selling or buying and the prediction becomes true.

The relationship between oil and the dollar has returned to what it should be: a directional relationship over a longer period of time, not a second-by-second link between the two. A weaker dollar means higher commodity prices. If we use the euro as an example, then in euro price terms the price should be similar, so the price of gold in euros in this scenario does not change as much as the dollar gold price changes. The reason the dollar is weakening versus the euro is normally fundamental - either worse economic news for the U.S or better news for Europe.

This has led us to a position where the energy traders are looking for something else to correlate with oil now that the speculators have dissipated, and they have found the Dow.

You may ask how this knowledge helps you determine what the currencies are going to do. The answer is another step in the chain of reactions. When the Dow goes up, oil follows it and because oil has gone higher (notwithstanding other influences such as fundamental economic news), currencies should strengthen. Where this does not make sense is that if stocks rally, normally bonds would be sold off. If bonds are sold, interest rates rise which would normally attract funds to the dollar. How do I explain this away? It's simply a matter of knee jerk reaction compared to a longer time frame. As interest rates typically move more slowly than the other markets, they normally do not create a minute-by-minute reaction unless their move is huge. However, the other markets and the dollar will be swayed by higher rates if they are sustained over a longer period in time, reversing the reaction that occurred on the short term.

I hope I have succeeded in pointing out how the market interrelationships have changed of late and that it helps you assess your foreign currency risk by looking at the current reasons why the markets are reacting the way they are.

Here is the caveat: the above explanation is today's new "normal." If stocks suffer a global fall out and fear takes over, money will flow to U.S. bonds exactly as it did a year ago and the dollar will strengthen as foreigners buy dollars to buy the bonds. In this scenario oil and commodities just follow the lead and get sold off; their importance has been diminished by the change in circumstances. This scenario would be defined as risk aversion. The opposite a higher risk appetite would follow the scenario described above with higher stocks commodities and lower dollar and bonds.