My most recent weekly commentary talked about the sudden shift in the trend of the US dollar and touched on the impact for commodity prices. While treasuries often concentrate on currency and interest rate risk, the huge increase in volatility and size of trends in commodities in recent years, means that controlling risk in this area can be more important than the currency exposure. The US dollar has a direct impact on commodity prices as they are priced in dollars and therefore cross market analysis of the major asset classes is necessary in order to understand major turning points. It is very rare of the major asset classes (stocks, bonds, dollar and commodities) to all shift direction at the same time, but is it critical to analyse when all of them have changed direction over a period of time.
In the current cycle, the base metals were the first to create a top. This change was even more striking when considering how the dollar continued to collapse. Now that the dollar has changed direction, this simply adds pressure to base metals.
The second asset class to change direction was bonds. The absolute low was also made in February but from a trend prospective it only broke out of a sideways pattern in April. What was also informative was that bonds rallied in spite of the final explosive surge in silver and crude, which was highly inflationary. These markets were the third to post a high in early May and collapsed after a speculative frenzy. This drop was accentuated by the US dollar shifting trend dramatically on unexpectedly dovish remarks from the president of the European Central Bank (ECB), Jean-Claude Trichet.
The final asset class that is signalling a top is the US stock market. So far, while a negative signal has appeared and the high was made on the day of Osama Bin Laden’s death (an unexpected news event), the market has not started to trade into a lower trend.
The conclusion for those needing to hedge commodity risk with additional exposure to the Australian dollar, is to carefully watch the US stock market. Any more serious breakdowns will bring risk aversion back into focus. The Australian dollar is particularly susceptible to weakness at such times and commodities will be under pressure as well. This suggests that there is no need to hedge unless both base metals and the Australian dollar make new highs for the year.
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