May 3, 2010

US Dollar Versus Crude Oil and Unleaded Gas

(Click to enlarge the graphic).

News of a rising US Dollar has been curiously absent in recent weeks, and all eyes are on Crude Oil - is something in the cards?

The semi-log weekly charts above plot the PowerShares DB US Dollar Index Bullish ETF (UUP, blue bars, both charts) versus the iPath S&P GSCI Crude Oil Total Return ETN (OIL, black bars, lower left) and the United States Gasoline Fund, LP ETF (UGA, black bars, lower right). A black inverted line chart has been added (inverse OIL on the left, inverse UGA on the right) atop each UUP plot, along with a cycle study (dervied from from Mar 08 - Jul 08). Blue dashed vertical lines denote dates forming the cycle study, with black dashed vertical lines denoting each successive cycle date. A 26 period price channel has been plotted on both OIL and UGA, and various Fibonacci retracement grids have been drawn on each chart.

As commodities go, it's generally accepted that both Crude Oil and Unleaded Gas are inverted to the US Dollar. As the greenback devalues, producers demand more Dollars for their product; as Dollars gain strength, this tension eases and energy costs (theoretically) abate. Academically, the direct negative correlation between the two instruments (Dollars and commodities) rings most true during signs of inflation. Living in a "petrodollar" world, investors and money managers learned to accept this thesis, perhaps contributing to the unprecedented Crude Oil bubble of 2008.

Theory is great in the classroom, but can sadly be a cruel teacher in a live market. Such was the case during the global meltdown of Oct 08 - Mar 09 when practically everything fell in unison. While outside the scope of this piece, much-touted non-correlation (which seemed so certain to continue) ultimately punished those expecting non-correlation benefits when "long only" any mixture of equitie and commodities; everything became completely correlated, and there was simply no place to hide. Long-standing relationships (in this case, inverted) were exposed for their unspoken weakness - even the most non-correlated assets can experience brief periods of correlation.

Armed with two powerful lessons - one academic, one practical - we turn our attention to the current relationship between Dollars and commodities. In doing so, consider the past 2 years dating to Mar 08 when the US Dollar bottomed ahead of the global equity collapse. For 4 months, as the US Dollar consolidated, Crude Oil and Unleaded Gas rose handily into Jul 08. As the financial crisis began to take shape, the US Dollar soared, and (true to form) the price of these commodities began to abate. Clearly, academic expectations were realized until Nov 08 when huge swings through Mar 09 were met with a brief period of decoupling (Dollar and commodities both falling in early 09).

Looking more closely at the period Jan 09 - Mar 09, we see that even Crude Oil and Unleaded Gas worked independent of one another, with the Dollar strengthening yet again into the Mar 09 equity lows. Crude Oil continued to fall while Unleaded Gas actually rose (seen on an inverted basis to be falling on the right UUP chart). The relationship between the US Dollar and this commodity were clearing not in sync, and was perhaps a sign of strength yet to come regarding prices at the pump. Anyone driving during this time in market history surely remembers the odd feeling of sub $1.50 gasoline so closely following more then $4.00 per gallon less than a year earlier. When did it all change? One could argue it the entire complex now reflects the bottoming in Unleaded Gas dating to Jan 09. Indeed, as the Dollar fell into Jun 09, Unleaded Gas rose inline with the fall - yet Crude Oil managed only to meander higher.

The Dollar itself seems to be marching to the beat of a cyclic drum formed between the Mar 08 low in US Dollars, and the apex of Crude Oil and Unleaded Gas in Jul 08. This cycle has coincided with nearly every swing high and low in the US Dollar since, and is - once again - signaling we are at a crossroads. On a price retracement basis, the Dollar is up against its 38% retracement from its last major high (measured cyclic swing to cyclic swing, Mar 09 - Nov 09). Likewise, Unleaded Gas is trying to break through the same level, namely its 38% price swing retracement when measured Jul 08 - Jan 09. Crude Oil, however, hasn't recovered nearly as much, leading us to wonder what might be next.

What lies ahead will be defined by the resolution of current patterns in these 3 instruments themselves. Both Crude Oil and Unleaded Gas are in the midst of a multi-week (if not multi-month) ascending triangle. Clearly both have been trying to break higher for some time, yet have failed to do so. In the classic sense of technical analysis, these patterns represent pending continuation and should resolve to the upside. From a business cycle perspective, they should break higher as well given we are past midway in the cycle of bonds up, stocks up, and (perhaps finally approaching) commodities up. Finally, 26-week price channels on the two commodities are tightening, signaling we have consolidated now for several weeks. The US Dollar is forming an ascending wedge itself, the natural resolution of which would be to the downside. Indeed, greenbacks have struggled since Mar 10 to sustain their rise, and attempted breakouts to the upside have been firmly rejected.

Whatever the outcome, cyclically we are at the crossroads. May has often proven to be a "shake out" month for commodities in the past - perhaps this month will be no different. The only question for the moment regards whether or not we will return to a state of non-correlation between Dollars and commodities, the outcome of which is an inverted relationship. Significant market trends always seem to "bounce" off their 38% retracement to (in turn) resume their former trend. Based on this fact alone, the case could be made for any of these markets to continue to the downside, yet current price action foretells a resumption of non-correlated tendencies between Dollars and commodities, with Energy breaking higher and the rise in Dollars waning. Should we fail to see this resolution, these markets are more likely than not to meander into Aug 10, the next cycle date in the study.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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