So it seems that the deflationary cycle has come to an end...for the moment. But there is still life left in the US dollar bull market, and thus further commodity deflation is highly likely.
While all eyes in the world of finance are focused on the drama in Europe with the potential for a Greek withdrawal from the Eurozone, many might have missed the latest developments in the commodities markets. As we've been noting for some time now, the deflationary undertow in the global markets has been pulling down commodity prices across the board since last summer. This has been most noticeable, perhaps, in the oil market, but true for copper, iron ore, corn and wheat futures, and a host of other commodities.
We all know the narrative on oil by now: the falling oil price is the result of a not-so-secret deal struck between John Kerry and his Saudi counterpart last summer as part of a plan to attack the State Department's erstwhile enemies financially, Iran, Venezuela and Russia amongst them. There are only two problems with that narrative. Firstly, the move hurts American producers (mostly profiting from the shale boom) in particular, as the lower oil price makes fracking unprofitable. And secondly, Saudi Arabia didn't actually do anything to start the price of oil plunging. They merely refused to cut back on production when prices were falling, thus helping things along.
So what caused the fall? Look at a chart of any major commodities index over the past six months and compare it to the DXY (US dollar index). The two are a perfect inverse fit. As the dollar began its bull run last July, commodity prices started tanking. The correlation is obvious, and given the dollar's world reserve status, the causation is not hard to detect, either. This current bout of deflation is primarily a result of the strengthening dollar, which is precisely what you would expect. So what began the strengthening of the dollar? Why, the end of QE3, of course, which was all but a done deal when the Fed released its June meeting minutes on July 9th, confirming they were looking to wind down the program last October.
But the dollar bull run seems to have hit a top, with the DXY failing to break the 95.0 mark despite three attempts in the past two weeks. And what did we see in the commodities markets? A bottom on all of the major indices at almost the exact same time.
So it seems that the deflationary cycle has come to an end...for the moment. But there is still life left in the US dollar bull market, and thus further commodity deflation is highly likely. The deciding factor is once again (no surprise here) the pronouncements of the central bankers. In this case, the dollar will rise and fall based on investor expectation that the Fed is going to raise interest rates this year. After January's (highly manipulated) payroll data came out strong across the board, it seems more likely than ever that the Fed will be raising rates this summer, meaning we're likely to see the dollar rising (and commodities falling) even further this year.
So if you want to know where commodity prices are going, keep your eye on the DXY. And if you want to know where the DXY is going, keep your eye on the Fed.