If you have been following my stuff, you will know that I’m a mega stock market bull — 2015 will be a huge year for equities. In Diggers and Drillers this week, I gave my readers more detailed analysis on why this will be the case.
But there’s something that keeps me up at night. And it may shock you that I’m talking about the US dollar.
Many commentators have been saying that now is the time to short (sell) the US dollar. For example, Steen Jakobsen, Chief Investment Officer at Saxo Bank, said:
‘The greenback will “significantly weaken” from the middle of the third quarter into the first quarter of 2015.’
In my view, shorting the US dollar now would be an extremely foolish move. I’m on the other side of the fence. I say, get ready to go long (buy) the US dollar.
Yes, the US economy has huge issues. But at the same time, it’s much bigger and in better shape than many other economies around the world. In Diggers and Drillers, I’ve written significant analysis on this topic. In my view, Europe is the greatest threat to the world economy — and this is no understatement.
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Its economy is working under a model of low growth, high unemployment, and increasing taxation and debt. It’s simply unrealistic to assume that debt can keep outpacing economic growth forever. Economic activity is only going to get worse in the future because rising taxes are choking growth.
The euro will break and fall to new lows against the US dollar. And gigantic amounts of capital will end up flowing into the US dollar over the next couple of years — the so called, ‘flight to safety’. My greatest fear is how much capital will flow into the US dollar. A rising US dollar will be the greatest threat to commodity prices and the real economy in the years ahead.
This brings me to the US dollar index.
The US dollar index is a good measure of the strength of the US dollar. It’s calculated using a basket of six currencies: the euro, yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
The basket of currencies is then weighted against the US dollar. Here’s a look at the current configuration:
And here lays the catch: The basket isn’t equally weighted. As such, it won’t give you a perfect indication of the US dollar’s strength. But it does a fair job.
Now you may be thinking, so what does this have to do with commodity prices?
Actually, it has a lot to do with commodities. You see, almost every commodity is priced in US dollars.
As the US dollar strengthens against other currencies, it will be more expensive for people outside the US to buy commodities. As such, for demand and supply to match, mathematically, commodity prices will fall.
The bottom line is, although not the be all and end all, a stronger US dollar isn’t good for commodity prices.
Let’s take a look at the technical picture. The chart below tracks the US dollar index. Each bar represents one week.
The above chart shows that the US dollar index is up over 5% since July 1. You can see this by looking at the blue arrow. In this case, it’s not surprising that gold, iron ore, crude oil, and virtually every other commodity under the sun are down by at least 5%.
The US dollar index is now trading just above the 50% Fibonacci retracement resistance level (84 US cents). Fibonacci retracements use horizontal lines to indicate areas of support or resistance.
But there’s some good news.
The slow moving stochastic indicator (SMSI) suggests that the US dollar is overbought.
The SMSI is now trending above the green line, signalling an immediate reversal is on the cards. The slow moving stochastic indicator follows the speed or the momentum of price. As a rule, the momentum changes direction before the price.
In this case, I wouldn’t be surprised if the US dollar index reversed back towards the 38.2% Fibonacci retracement support level of 82 cents soon. This would be good for commodity prices. It would also mean that the US dollar index would resume trading within its long term uptrend channel, shown by the double black lines.
But you may be wondering, why the sudden 5% move?
For starters, Scotland’s impact on the UK pound hasn’t helped. And if Scotland leaves the UK, expect the US dollar index to rise. The UK pound represents 12% of the index.
But this isn’t the main reason. As you’d expect, much of this move has to do with Europe. Europe makes up more than a 50% weighting in the currency basket.
This comes down to interest rates. As you’re most likely aware, the European Central Bank cut interest rates from 0.15% to 0.05% a fortnight ago. When accounting for inflation, Europe is now trading at negative interest rates. Europe’s negative interest rate environment won’t change — and it will probably cut rates again.
As Kris said yesterday in Money Morning, for months I’ve been telling my readers why the US will hike interest rates next year. Australia, because of overheated property sector, and the UK, because of its economic growth and property sector, will also raise rates.
When the US increases its interest rate next year, the US dollar index should rise. This is because the interest rate difference between the Eurozone and US widens. And with Europe’s economy and interest rates less attractive, capital moves elsewhere. Hence, investors keep selling the euro.
And this is my concern in the long run. Given that the euro is a currency experiment set up for political motives, its future doesn’t look good.
There is a lot of action to watch across Europe in the years ahead. As shown on the chart above, the US dollar index could easily be trading at 96 US cents by 2016/17. This would represent the 100% Fibonacci retracement level. This is just above the support level dating back to 1996.
And if the Euro collapses, it could potentially trade at 110 US cents. This would represent the 161.8% Fibonacci extension level. This isn’t an unrealistic forecast; the US dollar index traded at 120 US cents back in 2001.
The next financial meltdown is when you’re most likely to see these moves. As such, any move would be short lived. In this case, commodity prices may see some temporary volatility in the future. As a contrarian investor, this will be a great time to buy quality resource stocks.
The bottom line is watch the US dollar closely. It will have an impact on future commodity prices.
Jason Stevenson+
Resources Analyst, Diggers and Drillers
The post The Greatest Risk to Commodity Prices in the Years Ahead appeared first on Stock Market News, Finance and Investments | Money Morning Australia.
