U.S. dollar weakness has played a key role in generating hefty gains for metals prices and mining stocks in the past few years, but investors should beware that metals often come with dangerous edges.
An increasing correlation between swings in the U.S. dollar and base metal prices has some analysts and investors fretting that the bull market in commodities has become overly sensitive to U.S. monetary policy, which puts metals and a significant portion of the Canadian equity market more at the whim of the Federal Reserve than the economics of supply and demand.
“Never in the past two decades has the U.S. dollar exercised so much influence on the direction and fluctuation of metal prices,” said Clément Gignac, chief economist and strategist at National Bank Financial Inc. Any shift in sentiment on the U.S. dollar, triggered by a more aggressive tightening by the Fed, “could trigger a significant price correction on metal prices.”
Although the relationship between base metals and the greenback is weaker and more volatile than that between the dollar and gold, National Bank's research has found that for any gains made over the last 180 trading days by aluminum, 25 per cent of that gain can be attributed to a decline in the greenback. The dollar accounted for about 23 per cent of the move in zinc, 21 per cent for copper, and 20 per cent for nickel.
In the last six months, the London Metals Exchange's metals index — which combines the performance of copper, aluminum, lead, tin, zinc and nickel — has moved in near tandem with swings in the U.S. dollar. According to Bloomberg analytics, the index has seen a correlation of 0.8 with the Fed's index of trade-weighted currencies. A perfect correlation coefficient is 1.
The rally in the commodities market has been a boon for Canada's resource-rich stock market. The S&P/TSX composite index has climbed 11.3 per cent in the last year while the S&P/TSX's capped metals and mining index is up 33 per cent in the last 12 months and has more than doubled in the last three years.
The CRB metals index — composed of copper scrap, lead scrap, steel scrap, tin and zinc — has soared 110 per cent since November 2001 as the dollar has lost ground against the euro, yen and other currencies. A falling dollar makes metals, which are priced in U.S. dollars, more affordable to buyers in other currencies. Metals also become more affordable, and attractive, to hedge funds.
Metals prices have seen their second-best commodity bull market in the last five decades, after the rally between 1971 and 1974, Mr. Gignac said. However, he said the 39-month rally is starting to show its age, outlasting the typical 28-month duration of a commodity cycle.
“The risk of investing in the resource sector has increased in a significant way, given how much commodity prices have soared,” he said. “This is a more dangerous bull market because the U.S. dollar is playing a bigger role than it has in the past. If the regime shifts in the U.S., interest rate rises will accelerate, the U.S. dollar will stop falling and we could see profit-taking on the commodity market.”
Mr. Gignac argues that increasing the pace of rate hikes could stimulate U.S. savings patterns, prompting more Americans to save more and take advantage of the higher rates of interest paid on accounts. A subsequent downshift in consumer spending would help balance the trade deficit, which would in turn contribute to more dollar strength and exacerbate declines in metals prices.
Hedge funds, who have helped drive metals prices higher by placing significant bets on even greater gains, could also reverse their long positions on commodities on any sign of sustained U.S. dollar strength, Mr. Gignac noted.
“Suddenly, we could see significant profit taking on commodities,” which would have an immediate impact on Canada's stock market, Mr. Gignac said. “So I am telling my clients to be aware.”
Mr. Gignac recently recommended that investors take an “underweight” position on the resource sector.
© The Globe and Mail
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