May 12, 2010

Precious and Base Metals versus US Dollar

(Click to enlarge the graphic).

Gold is breaking to new highs, but not all metals are trending higher - inflation play, or flight to safety?

The daily bar charts above plot the PowerShares DB Precious Metals Fund (DBP, gold bars on the left) and the Powershares DB Base Metals Fund (DBB, grey bars on the right) versus the PowerShares DB US Dollar Index Bearish Fund (UDN, red line on each chart). Two individual trend indicators are plotted in the sentiment area of the chart. Black vertical dashed lines denote dates of interest, and red horizontal dashed lines denote prices of interest.

Fall 09 bore witness to a falling Dollar (UDN rising in red on both charts), but that trend reversed beginning in Dec 09. As might be expected, both Precious and Base metals rose in the face of greenback weakness. Though Base metals were slower to respond, the subsequent strengthening in the US Dollar (UDN falling) initially led to a devaluation in both Precious and Base metals alike - a relationship which faded, however, in Feb 10. But for a brief spike higher, the greenback range traded (UDN 26.51 to 27.01) until Apr 10. What happened next is telling a story everyone should be following.

Note that the range trading in US Dollars from Feb 10 - Apr 10 yielded higher prices in both Precious and Base metals. Taken in isolation, this might demonstrate a possible bias toward inflationary pressures. For a brief moment in time, the continued rise in US Dollars (UDN down) following the range trade produced weakened valuations in both Precious and Base metals. Precious metals, however, have since risen briskly - yet their Base counterparts have fallen precipitously. While not plotted, nearly every other commodity sector has acted in line with Base metals over this period. Their falling in near unison with Base metals perhaps tells us a supply / demand story is in play more than that of an inflationary tale, and warrants further consideration.

The question everyone should be asking is simple - is there any trend in commodities we can count on? The middle of the two sentiment plots above offers conflicting views as well between these two instruments. The blue line represents a longer period trending metric (two to three months), whereas the red line denotes shorter periods (two to three weeks). Precious metals (on the left) were in "trending mode" (blue line rising, left chart, middle sentiment indicator) as the Dollar weakened into Dec 09. That trend waned (blue line falling) until resuming again in Apr 10. Base metals, however, failed to really trend until Dec 09 (again, blue line rising on the right chart, middle sentiment indicator). The story has been mixed since, though the short-term trend (red line, right chart, middle indicator) has taken a significant dive in recent weeks. This doesnt bode well for Base metals (nor inflation), let alone any potential Fed response as regards interest rates. The table appears to be set, and the continued rise in US Treasuries has relentlessly signaled interest rate increases may be slow to arrive on scene.

Turning to the bottom indicator on both charts, we find a more salient series of points. This indicator is useful for identifying "over trending" or "under trending" moments in the market. When the black line (left or right chart, bottom sentiment indicator) ascends toward 1.000, the underlying market (Precious metals left, Base metals right) is exhibiting highly consistent trends. Based upon R squared (aka, the coefficient of determination) this indicator measures the tightness of returns themselves. The black line in this indicator basically judges the "tightness" of price action about a median line, and is useful for gauging the continuity of trending markets. Note that going into their previous peaks (Dec 09 for Precious metals, Jan 10 for Base metals), the indicator had achieved optimum levels (near 1.000). Both metals had "false starts" in Feb 10 (rising black line, both charts, bottom indicator) until true trends emerged again in Apr 10 - yet Base metals have not followed through. This too fails to foretell inflation.

It's likely that (for the moment, at least) the precipitous rise in Precious metals represents a "flight to safety" rather than a n inflationary play. Gold, silver, even platinum and palladium, are all up. This week's trading to date has served witness to the safe harbor investors are seeking in an increasingly complex world. That world is composed of inexplicable equity valuations and mounting global debt the likes of which few have seen. These markets are truly behaving in ways few can explain academically, let alone logically. One would think inflation would begin to rear its ugly head, yet we can find little to support the argument. Dollars continue to rise, as do US Treasuries, yet the broader commodity complex has largely stalled - except for Precious metals. As of this morning, commodity strength does appear to be evident outside of the Precious metals sector (see JJA and JJG), yet remains weak in others (see JJE and JJS). Until we see follow through across the entire commodity complex, this current move is more "flight to safety" than inflationary - and that serves as a warning that market strength in equities is being increasingly questioned.

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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