Drozd: Weak U.S. dollar lends underlying support to commodity prices

The U.S. dollar dipped below 74.00 last week, posting a 32-month low. Prices have not been this low since August 2008.

The U.S. dollar is the world’s primary reserve currency and it is traded at the IntercontinentalExchange (ICE), the world’s centralized price discovery point for the U.S. dollar index.

The U.S. dollar index is a measurement of the U.S. dollar relative to a basket of foreign currencies, which includes the Euro (57.6 per cent weight), Japanese yen (13.6 per cent weight), pound sterling (11.9 per cent weight), Canadian dollar (9.1 per cent), Swedish krona (4.2 per cent weight), and the Swiss franc (3.6 per cent weight).

The U.S. dollar index began in 1973 at 100.000. It reached a high of 148.124 in 1985 and a low of 70.805 in 2008.

The U.S. dollar index has been under pressure since June 2010, when prices failed to push through a key level of overhead resistance at 89.00 and quickly turned down, developing a two-week reversal.

Two-week reversal

This chart pattern indicates a change in direction. On the first week, the market establishes a new high for the rally and closes very strong at or near the high of the week.

The next week, prices open unchanged to slightly higher, but fail to make additional upside progress. Increased selling occurs early in the week and prices begin to turn back down. By week’s end, the market drops to around the preceding week’s lows and closes at or below the midpoint between the opening and closing price of the preceding week.

Market psychology: The two-week reversal is a 180-degree turn in sentiment. On the first day the longs (market participants who have purchased a futures contract on the expectation of higher prices) are comfortable and confident. The market’s performance provides encouragement and reinforces their expectation of greater profits.

The second week’s activity is psychologically damaging. It is a complete turnaround from the preceding week and serves to destroy or at least shake the confidence of those who are still long the market. The immediate outlook for prices is abruptly put in question.

Longs respond to weakening prices by exiting the market. Some sell to protect profits and others sell to cut their losses.

The U.S. dollar can and does have a huge impact on commodity prices. A strong U.S. dollar weighs on U.S. commodity prices, just as a weak U.S. dollar is supportive to prices. This is because it affects foreign nations’ purchasing power of U.S. commodities.

When the U.S. dollar is low, U.S. commodities appear on sale to the world. Demand picks up, stocks are drawn down, and commodities subsequently become much more expensive.

When the U.S. dollar index fell to a new low (A) in the spring of 2008, grain prices exploded to new historical highs. Shortly thereafter in the summer of 2008, the U.S. dollar index began to turn back up and grain prices collapsed.

In fact, in May 2010, grain prices stopped their relentless decline just as the U.S. dollar index peaked at 89.00 (B) and turned back down.

Commodity prices are once again heating up with gold, silver and corn trading at new historical highs now that the U.S. dollar index has slipped below the line of support (C) in the accompanying chart. Even livestock prices (cattle and hogs) are beginning to trade in a new higher range, with prices recently rallying to a new historical high.

I should add caution not to oversimplify the U.S. dollar index’s relationship to commodity prices. Although there is a strong correlation, it is only one of numerous factors affecting the ebb and flow of commodity prices.

Even though farmers will soon be busy with spring seeding, they should still watch the charts closely for pricing opportunities.

Send us your questions or comments about this article and chart.

— David Drozd is president and senior market analyst for Winnipeg-based Ag-Chieve Corp. The opinions expressed are those of the writer and are solely intended to assist readers with a better understanding of technical analysis. Visit Ag-Chieve online for information about grain marketing advisory services, or call us toll-free at 1-888-274-3138 for a free consultation.

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