From Invesco: While the dollar moved higher against global currencies in 2014 and 2015, headlines touting the dollar’s strength continued long after its price trend flattened out. Since then, the Federal Reserve adopted tighter monetary policy, leading many market prognosticators to predict a renewed rise in the US dollar. I was not among them.
In fact, it has been my contention for nearly two years that the dollar holds limited upside potential. My reasoning centers in large part on global interest rate convergence. That is to say, if interest rates in Europe and other developed markets rise by a greater margin than rates in the US, tighter Federal Reserve policy wouldn’t necessarily equate to a stronger dollar. And indeed, this has been the case thus far in 2017. Interest rate spreads between the US and other regions have converged significantly. From Dec. 26, 2016, through July 31, 2017, the US dollar was down 10.1%, as measured by the US Dollar Index (DXY).
Movements in the US dollar since 2009
Source: Bloomberg L.P., July 31, 2017. Investments cannot be made directly into an index.
The effects of a lower US dollar on commodities
For investors in alternative assets, movements in the dollar can have significant implications. That’s because commodities priced on global exchanges in US dollars, such as oil, agricultural products and metals, have historically had an inverse relationship to the US dollar; i.e., a weak dollar has supported commodity prices, and vice versa.
I had my team run a regression analysis based on rolling 12-month returns for the US Dollar Index versus rolling 12-month returns for commodities, as measured by the DBIQ Optimum Yield Diversified Commodity Index. We ran our numbers beginning in 2010 to capture the post-financial crisis relationship. The results showed a significant -0.75 correlation between the US dollar and commodity prices, with the strongest commodity performance represented by the oval in the chart below.
Commodities performed best when the dollar was weakest
Source: Bloomberg L.P., July 31, 2017. Investments cannot be made directly into an index. Past performance is not a guarantee future results.
Some of our findings:
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Since the financial crisis, when the dollar was down more than 5.6% on a rolling 12-month basis, the DBIQ Optimum Yield Diversified Commodity Index had an average total return greater than 30%. In fact, the worst return generated by the index during periods of dollar weakness was 18.9%.
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With the dollar already down 10% from its post-election highs through July (and down 5.3% from pre-election levels), even a flat US dollar would put the rolling 12-month return of the US Dollar Index into that same -5.6% territory. Although past performance is no guarantee of future results, if the dollar fell to that degree, it could again put commodities into a rarefied historical risk/return category.
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Using DXY’s high on Dec. 28, 2016, as a baseline, the US Dollar Index (currently trading near $93) would need only stay below $97.44 for commodities to land in the circled quadrant above by year-end 2017.