Monday Markets — It’s All Connected

Monay, 29 March 2021
Melbourne, Australia
By Greg Canavan

[3 min read]

Dear Reader,

As you know, last week I talked about the rising US dollar. It’s been steadily getting stronger (against other fiat currencies) since the start of the year.

In Thursday’s US trading session, it traded at its highest level since mid-November 2020.

How can the US dollar rise in the face of a Fed ‘printing money’ and multitrillion-dollar fiscal deficits?

The simple answer is that investors believe the US economy is recovering, leading to higher market interest rates (bond yields), which attracts capital, which in turn pushes up the value of the dollar.

A strong US dollar is often associated with weaker global equity markets. This is usually the case when a rising dollar is the result of fears of an economic slowdown and falling bond yields. In this environment, capital acts defensively and seeks shelter in bonds and US dollars.

But the dollar and equity markets can also do quiet well in reflationary periods, like the one we are in now. In this environment, a recovering economy leads to rising bond yields (due to a healthy outlook), which attracts capital into the US economy.

For example, in the last reflationary period beginning in 2016, the dollar and stock markets rose in tandem. Then the dollar weakened all throughout 2017 as Trump’s tax cuts revealed trillion-dollar deficits. The markets loved this too.  

In general, during periods of global growth, a falling US dollar is a positive for stocks. That was certainly the case throughout 2017.

But at the start of 2018, the dollar began rising. And the S&P 500 (the global stock market barometer) struggled. It finished the year with a crash. Stocks only turned around when the Fed committed to easing off on its tightening path. This removed the threat of a sharp economic slowdown.


Source: Optuma

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I give you this background to show that there is not a strong correlation between the US dollar and global stocks. They can often do well together, especially in the early stages of a reflationary period.

But I guess that’s the question, isn’t it? Are we still in the early stages of this recovery? Or did the global lockdowns do so much economic damage that the recovery will only be shallow and short lived, before the next bout of stimulus comes through?

If the US dollar continues higher and the S&P 500 starts to struggle, perhaps it’s an indication of the latter?

Leaving that aside for now, a rising US dollar does have implications for Aussie investors. Firstly, a strong US dollar isn’t usually correlated with rising commodity prices. Commodities are an anti-US dollar trade.

That was certainly the case over the past year. The chart below shows the Thomson Reuters CRB Commodities Index (blue line) rising while the US Dollar Index fell.


Source: Optuma

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Commodities took about a month to notice the peak in the US dollar last year. The dollar peaked in March while commodities bottomed in April. Similarly, it’s taken commodities a month to notice the bottom in the US dollar that occurred in January this year.

By the way, I’m not suggesting the bull run in commodities is over. But it’s been a very strong run so a correction and period of consolidation (coinciding with US dollar strength) would not surprise.

One part of the commodity market that bears particularly close watching is iron ore. I’ve shown this chart before. It’s the yuan/US dollar exchange rate with the iron ore price over the top. As you can see, it’s quite a correlation.


Source: Optuma

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A strong yuan relative to the US dollar correlates to a higher iron ore price. If the US dollar is in for a period of strength, it suggests the iron ore price will fall.

Australia’s iron ore miners are already expecting it. Fortescue Metals Group Ltd [ASX:FMG] peaked back in January. The March low represented a near 30% correction. With the moving averages looking like they will soon cross to the downside, I’d be wary of seeing this as a buy the dip opportunity.


Source: Optuma

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Rio Tinto Ltd [ASX:RIO] also hit its lowest price since November last year recently. It too looks like it could be moving into a downward trend and a period of underperformance.


Source: Optuma

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That this is occurring in Australia’s largest export market at the same time as fiscal support measures such as JobKeeper drop off is interesting to say the least.

From here, it will be important to keep an eye on 10-year Aussie government bond yields. The chart below shows that yields peaked at nearly 1.9% on 25 February. Since then, the market has moved sideways. Is it just a pause in the reflationary trend? Or is the bond market about to roll over and signal a renewed slowing of the economy?


Source: Investing.com

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I don’t know the answer to that.

But if iron ore prices turn down from here, and fiscal stimulus drops off, it does represent the removal of a decent plank of support for the Aussie economy.

So in addition to keeping an eye on the US dollar, I would watch Aussie 10-year bond yields too. A fall below, say, 1.6%, might be a sign the ‘V-shaped recovery’ is over…already. But if yields keep pushing higher, the reflationary party is alive and well.

Continue below for Murray Dawes’ ‘Week Ahead’ update. Today, Murray discusses how after a huge rally last year, this rare earth hopeful fell back to Earth with a thud over the last couple of months and it could be setting up a great opportunity to jump on one of the world’s biggest rare earth projects.

Cheers,
Greg


[WATCH] One for the Punters

By Murray Dawes

 

The stock I discuss in the ‘Week Ahead’ video today has the potential to be a large force in the rare earths market.

Many of you will guess the name of the company in the blink of an eye because they have been working on their project for years.

They saw incredibly strong buying over the last year as excitement built that they would receive the final go ahead to develop the project. But at the 11th hour the market has gotten cold feet and the stock crashed 50% in the last couple of months.

The community consultation on the project has been extended and there are fears that elections may bring in a team that is against the project going ahead. The election is scheduled for 6 April, so we aren’t far away from finding out whether the project has legs.

There is large downside in entering the stock before all of the issues have been ironed out, so it is a very high-risk situation, but the upside is looking immense if things go their way.

Regards,

Murray Dawes Signature

Murray Dawes,
Editor, Pivot Trader