Commodites and the U.S. Dollar Index Correlation

Commodities and the U.S. Dollar

The inverse relationship between bonds and commodity prices and the positive relationship between bonds and equities have been examined. Now the important role the dollar plays in the intermarket picture will be considered. As mentioned in the previous chapter, it is often said that a rising dollar is considered bullish for bonds and stocks and that a falling dollar is considered bearish for both financial markets. However, that statement doesn't always hold up when examined against the historical relationship of the dollar to both markets. The statement also demonstrates the danger of taking shortcuts in intermarket analysis and the necessity to refer to the experts via some job search websites not to become a loser.

The relationship of the dollar to bonds and stocks makes more sense, and holds up much better, when factored through the commodity markets. In other words, there is a path through the four sectors. Let's start with the stock market and work backwards. The stock market is sensitive to interest rates and hence movements in the bond market. The bond market is influenced by inflation expectations, which are demonstrated by the trend of the commodity markets. The inflationary impact of the commodity markets is largely determined by the trend of the U.S. dollar. Therefore, we begin our intermarket analysis with the dollar. The path to take is from the dollar to the commodity markets, then from the commodity markets to the bond market, and finally from the bond market to the stock market.

THE DOLLAR MOVES INVERSELY TO COMMODITY PRICES

A rising dollar is noninflationary. As a result a rising dollar eventually produces lower commodity prices. Lower commodity prices, in turn, lead to lower interest rates and higher bond prices. Higher bond prices are bullish for stocks. A falling dollar has the exact opposite effect; it is bullish for commodities and bearish for bonds and equities. Why, then, can't we say that a rising dollar is bullish for bonds and stocks and just forget about commodities? The reason lies with long lead times in these relationships and with the troublesome question of inflation.

It is possible to have a falling dollar along with strong bond and equity markets. Figure 5.1 shows that after topping out in the spring of 1985, the U.S. dollar dropped for almost three years. During most of that time, the bond market (and the stock market) remained strong while the dollar was falling. More recently, the dollar hit an intermediate bottom at the end of 1988 and began to rally. The bond market, although steady, didn't really explode until May of 1989.

FIGURE 5.1
THE US. DOLLAR VERSUS TREASURY BOND PRICES FROM 1985 THROUGH 1989. ALTHOUGH A RISING DOLLAR IS EVENTUALLY BULLISH FOR BONDS AND A FALLING DOLLAR IS EVENTUALLY BEARISH FOR BONDS, LONG LEAD TIMES DIMINISH THE VALUE OF DIRECT COMPARISON BETWEEN THE TWO MARKETS. DURING ALL OF 1985 AND MOST OF 1986, BONDS WERE STRONG WHILE THE DOLLAR WAS WEAK.

COMMODITY PRICE TRENDS-THE KEY TO INFLATION

Turns in the dollar eventually have an impact on bonds (and an even more delayed impact on stocks) but only after long lead times. The picture becomes much clearer, however, if the impact of the dollar on bonds and stocks is viewed through the commodity markets. A falling dollar is bearish for bonds and stocks because it is inflationary. However, it takes time for the inflationary effects of a falling dollar to filter through the system. How does the bond trader know when the inflationary effects of the falling dollar are taking hold? The answer is when the commodity markets start to move higher. Therefore, we can qualify the statement regarding the relationship between the dollar and bonds and stocks. A falling dollar becomes bearish for bonds and stocks when commodity prices start to rise. Conversely, a rising dollar becomes bullish for bonds and stocks when commodity prices start to drop.

The upper part of Figure 5.2 compares bonds and the U.S. dollar from 1985 through the third quarter of 1989. The upper chart shows that the falling dollar, which started to drop in early 1985, eventually had a bearish effect on bonds which started to drop in the spring of 1987 (two years later). The bottom part of the chart shows the CRB Index during the same period of time. The arrows on the chart show how the peaks in the bond market correspond with troughs in the CRB Index. It wasn't until the commodity price level started to rally sharply in April 1987 that the bond market started to tumble. The stock market peaked that year in August, leading to the October crash. The inflationary impact of the falling dollar eventually pushed commodity prices higher, which began the topping process in bonds and stocks.

FIGURE 5.2
A COMPARISON OF BONDS AND THE DOLLAR (UPPER CHART) AND COMMODITY PRICES (LOWER CHART) FROM 1985 THROUGH 1989. A FALLING DOLLAR IS BEARISH FOR BONDS WHEN COMMODITY PRICES ARE RALLYING. A RISING DOLLAR IS BULLISH FOR BONDS WHEN COMMODITY PRICES ARE FALLING. THE INFLATIONARY OR NONINFLATIONARY IMPACT OF THE DOLLAR ON BONDS SHOULD BE FACTORED THROUGH THE COMMODITY MARKETS.

The dollar bottomed as 1988 began. A year later, in December of 1988, the dollar formed an intermediate bottom and started to rally. Bonds were stable but locked in a trading range. Figure 5.3 shows that the eventual upside breakout in bonds was delayed for another six months until May of 1989, which coincided with the bearish breakdown in the CRB Index. The strong dollar by itself wasn't enough to push the bond (and stock) market higher. The bullish impact of the rising dollar on bonds was realized only when the commodity markets began to topple.

FIGURE 5.3
A COMPARISON OF THE BONDS AND THE DOLLAR (UPPER CHART) AND COMMODITY PRICES (LOWER CHART) FROM LATE 1988 TO LATE 1989. THE BULLISH IMPACT OF THE FIRMING DOLLAR ON THE BOND MARKET WASN'T FULLY FELT UNTIL MAY OF 1989 WHEN COMMODITY PRICES CRASHED THROUGH CHART SUPPORT. TOWARD THE END OF 1989, THE WEAKENING DOLLAR IS BEGINNING TO PUSH COMMODITY PRICES HIGHER, WHICH ARE BEGINNING TO PULL BONDS LOWER.

The sequence of events in May of 1989 involved all three markets. The dollar scored a bullish breakout from a major basing pattern. That bullish breakout in the dollar pushed the commodity prices through important chart support, resuming their bearish trend. The bearish breakdown in the commodity markets corresponded with the bullish breakout in bonds. It seems clear, then, that taking shortcuts is dangerous work. The impact of the dollar on bonds and stocks is an indirect one and usually takes effect after some time has passed. The impact of the dollar on bonds and stocks becomes more pertinent when its more direct impact on the commodity markets is taken into consideration.