This year has been one of the unexpected correlations.
For a time, for example, both risk-on and risk-off assets cratered together, as investors smashed the sell button on everything they owned. Contrary to conventional wisdom, Treasuries and stocks collapsed together, too, while many commodities boomed higher. Yet, as the inflation trade (short Treasuries, long the U.S. dollar and commodities) has begun to unwind itself, we are starting to see the relationships between asset classes normalize. Somewhat. That said, there is still a lot of work to do. Nevertheless, a few notable developments are jumping out at us and have been put on the radar.
Dollar Vs. Commodities
In a more normal market, commodities move higher as the dollar weakens and lower as the dollar strengthens. But this year we witnessed a rare phenomenon in which both the dollar and commodities (energy and agricultural, but not precious metals) rallied sharply together. In the case of the energies, over the previous 180 trading days, crude oil and the dollar have settled in the same direction 80% to 90% of the time, this correlation usually behaves in the opposite manner. Over the last 30 trading days, the correlation between the two has shifted to a negative correlation of 80% to 90%, so it has mostly normalized (for now). This is important in that it suggests that, perhaps, the market is moving past the "black swan" events that triggered unusual market behavior.
Energies Vs. Other Commodities
What is interesting is the consistency of the correlation between oil and agricultural commodities. Whether we run data on the previous 30 trading sessions or 180 trading sessions, there is a strong positive correlation between energy and agricultural commodities. In other words, as goes oil so goes the rest of the commodity complex (except for precious metals). If the September oil futures can't clear and hold $100 per barrel, it doesn't bode well for the agricultural commodities. In fact, we are expecting any near-term strength in oil to fail somewhere between $97 and $102 per barrel; this would be a hint toward weakness in other commodities.
Precious Metals Vs. the Buck
In a normal market, the correlation between gold and the dollar is sharply negative. As one moves one way, the other is expected to move in the opposite direction. Yet, over the previous 180 trading days, gold and the U.S. dollar index have traded in opposite directions only 20% to 30% of the time. That said, the correlation appears to be normalizing in recent weeks (since the dollar peaked in mid-July). This is because market expectations of higher interest rates have declined to leave the greenback slightly less attractive vs. lower interest rate-bearing currencies such as the euro.
Going forward, we expect gold and the dollar to trade sharply inversely. Depending on what the dollar does at critical pivot levels, this could mean a breakout to the upside for gold, or failure at trendline resistance.
Here is what we see on the charts:
The dollar rally has been stunning, but the index is testing previous breakout levels. If we see the dollar break below the band of support from 104.50 to 103.50, we would likely see a full reversion to pre-war levels. This shouldn't be surprising, we have seen commodity markets give back all of the Russian invasion gains, it would be fitting for financials (Treasuries, stocks, and currencies) to do the same.
Being a gold bull has been a pain trade for months. In early 2022, it performed well as traders flocked to safety and attempted to hedge inflation, but in the end, it was a nightmare for most. Upside volatility was treacherous, even those who were long the market at the right time likely had a hard time holding on and might have even found themselves chasing prices at the wrong time. Since peaking in early March, gold has performed poorly, which likely caught many by surprise (guilty). If record inflation and a potential world war isn't the time to hold gold when is?
The answer is when nobody else wants it. Gold isn't a buy-and-hold commodity as some assume it to be. It is a great way to diversify away from traditional assets, but the best time to own it is when no one else wants to. Mid-July was one of those times. The gold rally is up against trendline resistance. How this week closes (above or below the trendline) will likely set the tone for the next month or two.
Like commodities, Treasuries are likely going for the round trip to pre-war levels.
What to Do Next?
What worked earlier in the year probably won't work going forward as the markets attempt to normalize from two consecutive black swan events (Covid shutdown and potential world war). The currency market likely holds the key to market trends going into the year's end. Stay on your toes!
