NEGATIVE CORRELATIONS
Cause or effect: How significant is the EUR/USD to European Grain and Oilseeds markets? Chart 1
Source: Thomson Reuters Commodity Index vs USD Index Chart 2: OECD G-7 CPI (yoy %, since 2000)
5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0
Source: Bloomburg - G7 Inflation since 2000
ADMISI’s Paul Mylchreest has mentioned in previous editions of The Ghost in the Machine that a firming USD acts as a ‘Global Fed Funds Rate’ which raises some interesting questions over the inflationary trade combined with a continuingly stronger USD. We therefore have a diverging theme and our inverted relationship of higher dollar and lower commodity values has become disconnected. Running the correlations on the Thomson Reuters Commodity Index and the USD index from 2016 onwards, gives a reading of 0.3 which suggests a minor positive correlation. This implies that a rising dollar is supportive for commodities; however, the golden rule of correlation statistics is that ‘correlation is not causation’.
A strengthening USD presents clear headwinds to the commodity recovery reflecting an inverse relationship between them. This is clearly evident from a comparison of the Thomson Reuters Commodity Index with the USD Index which illustrates the impact of a firming USD to the benchmark (see Chart 1 for reference).
Statistical analysis using the correlation coefficient can show the numerical significance of this relationship. A value of + 1 would show a perfect positive correlation, meaning that as one variable rises, the second rises too. A reading of zero indicates no relationship and conversely a score of -1 indicates negative correlation, telling us that as one value increases the other decreases. Looking at data going back to 2000, the Thomson Reuters Commodity Index has a correlation of -0.79 to the USD Index and therefore shows a significant negative correlation.
2016 therefore has defied expectations across the commodity index and the story is no different in grains. Wheat at the Chicago Board of Trade has a correlation with the Dollar Index of -0.72 based on continuation data back to 2000; however, values in 2016 firmed 12% from 10 year lows at the same time as the dollar index firmed 10% and are trading above $100. Historically, the evidence suggests that this new trend is unsustainable but if we have learnt anything from 2016 then it is to expect the unexpected. Brexit and Trump have produced some seismic currency moves and the diverging monetary policy from the US Fed compared to the rest of the world’s central banks will continue to support the dollar appreciation train.
12 | ADMISI - The Ghost In The Machine | January/February 2017
The expectation in 2017 for rising inflation, as shown by the below chart, suggests an underlying recovery in commodity values, which we have already seen to some extent from 2016 ‘lows’. We know the narrative that President Trump signifies reflation, and measures to pull back legislation under the Dodd-Frank Act will surely add leverage and liquidity to traders’ balance sheets. Latest forecasts from the US Fed look for inflation to rise to 1.9% in 2017 before notching up to 2% in 2018 which is a picture mirrored in the UK with the Bank of England forecast for inflation peaking at 2.8% in the first half of 2018. In isolation, inflation is therefore supportive of commodity values. However, the two-year Bull Run in the USD, which started in 2014 Q4, will present significant headwinds (see Chart 2 for reference).
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
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