Don't Shy Away From an Ugly Dollar

 | Feb 24, 2012 | 12:00 PM EST  | Comments
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UUP

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This commentary originally appeared Feb. 24 at 10 a.m. on Real Money Pro – Click here to learn about this dynamic market information service for active traders.

It's been a good month for commodities bulls, but is this commodities rally ending or is it just beginning? If the chart of the U.S. Dollar Index is any indication, signs point to further gains in commodities prices.

Not long ago, we kept hearing about the strong U.S. dollar. But remember: when we measure the strength of the dollar, we are comparing it to other currencies. The largest currency in the basket most frequently used to measure the strength or weakness of the dollar is the euro. It's a lot easier to look like a supermodel when the yardstick is Quasimodo.

Now that fears of a European credit meltdown have been allayed, or at least delayed, the market has wasted no time beating the greenback with an ugly stick. Since commodities like oil and gold are priced in dollars, a falling dollar can be one of the driving forces behind rising commodities prices.

Source: TradeStation

Source: TradeStation

That beating may not be over. Looking at the daily chart of the U.S. Dollar Index, we can see a bearish head-and-shoulders pattern has formed over the past three months. A break of the neckline, located at about 78.50, would jeopardize the dollar, and a clean break of 78 would likely send commodities prices higher.

Commodities prices don't exist in a vacuum, and there are many factors at play. With oil, there are geopolitical factors to consider, as well as supply and demand. Let's not forget there have been well-documented cases of price and supply manipulation, although elected officials overplay blaming the speculators. In short, no single factor drives the price of oil.

Meanwhile, we can't ignore the historically significant relationship between oil and the dollar. The first of two charts below from the St. Louis Fed represents the price of oil since the beginning of this century, and the second chart shows the U.S. dollar.

Source: St. Louis Fed

Source: St. Louis Fed

Source: St. Louis Fed

The inverse relationship between the two is plainly visible: when the dollar falls, oil rises, and vice versa. So a break in the head-and-shoulders pattern in the $DXY will almost certainly place upward pressure on commodities prices, including oil.

Even recently, the relationship between oil and the dollar is visible. In the comparison chart below, the dollar is represented by the PowerShares DB U.S. Dollar Index Bullish (UUP), in green, and oil by the U.S. Oil Fund LP (USO), in black. There is a visible relationship between the dollar and oil, as peaks in the former coincide with troughs in the latter (arrows).

Source: TradeStation

Source: TradeStation

As oil ramps up on the hard right edge of the chart, the greenback appears to turn lower. Charts are never 100% reliable, but a downturn in the dollar would lend this commodity rally some sustainability.

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