After heavily loaded easing from ECB commodity market particularly metal did react positively but not really.
A strong dollar and low interest rates
Nowhere was the current trend of currency decoupling more apparent than in the relationship between the euro currency and the Swiss currency. When the Swiss abandoned the 1.20 cap against the euro, all hell broke loose. It was a watershed event in that it was a departure from coordinated action. At the same time, the move was a departure from the transparency that Central Banks exhibited over recent years.
Another example of decoupling is the relationship between the U.S. currency and the euro. A move that commenced in May 2014 has pushed the dollar to levels that few analysts predicted. It is probable that this move and trend will push the euro lower quickly and decisively.
(click to enlarge)
Over the past 8 months, there has been a significant breakdown in the relationship between the euro currency and the dollar. As the chart illustrates, the euro is trading at the lowest price since September 2003, and the technical target is now the lows of that month - which is an exchange rate of $1.0759, another 4% below where the relationship closed on January 23, 2015. An increase in open interest in euro futures contracts, the total number of long and short positions on the futures exchange, generally means that a trend will continue - it is a bearish technical signal. Finally, the relatively low level of monthly historical volatility, which currently stands at under 7.8%, means that the move has been slow and steady. Currencies generally have low volatility, and they tend to trend for long periods. Historical weekly volatility stands at 8.7%. The euro has been weak; however, other currencies have also moved lower against the dollar over recent months.
Continued deflationary pressures in Japan have weakened the yen. Commodity currencies, the Australian and Canadian dollars, have also moved lower in relation to the dollar. The Australian dollar broke below the 80 level last week for the first time since July 2009. Canada lowered interest rates last week, which weakened the loonie. Low interest rates around the globe have been stimulative tools. Interest rates in the United States remain at extremely low levels, with the 30-year bond closing at over 150 on January 23. Meanwhile, in some nations, interest rates are negative; banks are charging depositors to hold their money. Stagnation in the eurozone is a global problem; stagnation in Japan has been a long-term problem. China has begun to slow; growth in 2014 was the lowest in a quarter of a century. China is likely to lower interest rates in 2015. They may even devalue the RMB in an effort to stimulate their giant economy.
However, Europe has recently taken center stage. The European Central Bank President, Mario Draghi, announced the long-expected policy of quantitative easing last week. The ECB will purchase 60 billion euros worth of sovereign debt per month commencing in March 2015 and out to September 2016. An extension of the program, if conditions warrant, seems likely. This caused the euro to fall further against the dollar as European interest rates dropped, making the greenback even more attractive. After all, the dollar offers both a better yield and the high probability of capital appreciation. One of the main effects of a stronger dollar has been weakness in industrial commodity prices.
Industrial commodities continue to languish
Commodity prices peaked in 2011, and have moved lower since. In 2014, key industrial commodities picked up downside steam. The price of iron ore, the main ingredient in steel, has fallen to low levels, below the cost of production for high-cost producers. Prices for the commodity fell to new lows last week, below $67 per dry metric ton. Steel is a basic building block of infrastructure, and the slowdown in China weighs heavily on this industrial commodity. Iron ore prices fell throughout 2014, but it was action in the crude oil market that really stoked the flames of deflationary pressures. Crude oil, which was trading at $107.73 per barrel in June, closed on January 23 at $45.59. The fall in crude oil highlights both a supply surplus and contraction in demand for what is perhaps the most important industrial commodity in the world. The politics of the oil market have also contributed to the downside price adjustment, but as an industrial commodity, crude oil demand has clearly decreased in a global economic climate of deflationary pressures. Finally, and most recently, an industrial commodity that often acts as a barometer for global growth has broken downside support. The price of copper fell below the June 2010 lows of $2.72 per pound, and closed on January 23 at $2.4950. Copper is yet another industrial commodity whose value has suffered in response to a slowing global economy and a rising U.S. dollar. Historically, the dollar and commodity prices have a negative correlation. When the dollar moves lower, commodity prices tend to rise, and vice versa. However, in 2015, there is an interesting divergence developing between the greenback and one sector in the commodities market.
Divergence - precious metals
On a historical basis, precious metals are generally highly sensitive to moves in the U.S. dollar. The old saying goes, "dollar up, gold down," but that is not what is happening, at least so far in 2015. Gold was down 4.4% in 2014 - as of January 23, gold has moved 9.3% higher in 2015. Silver, which tends to be more volatile than gold, was down by 22.82% in 2014. In the first 23 days of 2015, the price of silver has rallied by 17.5%. Things are apparently different today from past years. Gold and silver both are acting rationally. They are reflecting two issues that have gripped the world.
First, these precious metals have dual roles. They are commodities, but are also currencies. In fact, gold and silver were means of exchange long before the currencies of today existed. Gold and silver are stores of value, but they yield no interest. In a world of low, or in some cases negative interest rates, gold and silver can compete as currencies, as they have intrinsic value, because precious metals are finite assets. Consider the fact that those who held precious metals rather than euros in Europe, yen in Japan or, most dramatically, rubles in Russia maintained their wealth. The second reason that gold and silver are diverging from their traditional negative correlation with the value of the U.S. dollar is that fear of the unknown has gripped the world. Recent terrorist attacks in Australia, France, and a raging war in the Middle East and abroad that pits the traditional world against a new breed of radical religious extremists has resulted in uncertainty. In times of uncertainty, precious metals have often attracted increased interest and price appreciation.
This divergence between precious metals and the value of the dollar and other industrial commodity prices is unprecedented. Many believe that gold and silver are barometers of inflation. However, today despite paper currency printing via policies of quantitative easing, governments around the world are not concerned with runaway inflation. In fact, Central Bankers have expressed concern about low inflation levels.
A 2% inflation target
Both the European Central Bank and the U.S. Federal Reserve have set a 2% target for inflation. With falling commodity prices, inflation is running far below targets. This presents additional deflationary pressures on economies around the world. Even in the United States, where economic activity has picked up, low inflation rates could slow down short-term interest rate increases, which the Fed projected for 2015.
There is a fine line between deflation and inflation. Quantitative easing policies are essentially a license to print more paper currency. That printing is inflationary, in theory. Lower industrial commodity prices are just the opposite - deflationary. What we must remember is that commodity prices tend to be far more volatile than other asset prices. It is common for a commodity to double or half in value in a very short time. Perhaps the divergence between dollar strength and strength in gold and silver highlights the risk of fears of current deflation and future inflation.
More bad news for the euro on the way
Given fears of deflation, low interest rates, quantitative easing, a strong dollar, low industrial commodity prices, and rising precious metals prices, we find ourselves at an interesting time in economic history. This could mean that we shall see tremendous volatility ahead in all markets.
The current trend in currency markets seems set to continue. On Sunday, July 25, Greeks went to the polls and elected a new government. The Syriza party recorded a landslide and wider-than-expected victory in the elections. Syriza ran on an anti-austerity platform. Their leader, Alexis Tsipras, promised voters he would negotiate the austerity measures put in place by the ECB. This victory will surely weaken the ECB, and it serves as a precedent for future elections in southern European nations that will go to the polls later this year. The sweeping victory by Syriza will, at the least, further weaken the value of the euro currency. Of course, southern European sovereign defaults could have even more dire ramifications for the euro zone.
Expect the value of the euro to continue to drop against the dollar in 2015 - my target remains parity. For now, industrial commodity prices will remain weak. The next shoe to drop is probably copper, which seems set to move lower, perhaps below the $2 per pound level over coming months. Gold and silver have retained their values and appreciated in price. These precious metals are signaling big market volatility, in all asset classes, on the horizon.
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