Conclusion: Given the historical inverse correlations, a strengthening U.S. dollar is likely to continue deflating key commodity prices, which is positive, on the margin, for the U.S. economy.
One the more bullish factors in our global macro models as of late is the strength in the U.S. dollar. In the short term, this is viewed as a flight to safety as global asset allocators get increasingly concerned about the outlook of the euro and the global economy and naturally reallocate funds into U.S. dollar-denominated assets. In both the short term and long term, a strong U.S. dollar has one key positive benefit, which is a Deflation of the Inflation.
As we’ve consistently highlighted over the course of the past three years, the key driver of many global asset prices has been and will continue be the direction of the U.S. dollar versus other major currencies. In the chart below, we’ve charted the U.S. Dollar Index versus WTI oil and copper going back three years. In fact, according to our analysis the correlation between the U.S. dollar index and both copper and oil going back three years is -0.77 and -0.68, respectively.
The immediate term impact of Deflating the Inflation is at the gas pump in the United States. As of last week’s retail pricing across the United States, gasoline was priced at $3.51 per gallon and diesel was priced at $3.79 per gallon. On year-over-year basis, as of last week, the price in gasoline is up +29.9% and the price of diesel is up +28.3%. On a year-over-year basis, this is obviously not great news, but gas prices are also now at their lowest level since March 2011 and prices have been declining for the last four weeks, so, on the margin, we are seeing some alleviation of the energy consumption tax.
In the short term, gasoline demand has been proven to be inelastic, so when prices change demand does not change meaningfully. Therefore, it is likely that these gas savings potentially get funneled back into other areas of consumer spending.
As a frame of reference for the potential impact to the economy of changing energy prices, according to the Energy Information Administration in 2009 the United States consumed roughly 19.2 MM barrels of oil per day (2/3rds in transportation alone). This equates to just over 7 billion barrels of oil per year. Thus, a $10 deflation of the price of oil on an annualized basis leads to $70 billion that can be reallocated within the economy. In aggregate terms this decrease in the price of oil has a potential positive impact of ~+0.6% on GDP growth.
As an interesting aside, the only two major commodities that have shown a positive correlation to the U.S. dollar over the last three years are natural gas and lumber with +0.49 and +0.62, respectively. On natural gas, this is somewhat understandable as natural gas, due to transportation costs, is a localized market that is priced based on local supply and demand dynamics. The lumber point is more interesting and seems to at least tangentially suggest what we’ve often theorized, which is that a strong dollar will lead to a willingness by foreign investors to purchase excess U.S. real estate assets (and thus buoy the price of housing materials).
As it relates to correlations, another key risk point we wanted to highlight is globally increasing correlations between markets and asset classes. This is occurring in fixed income markets versus equities (at a 40-year high in Europe according to reports), in components of the emerging markets versus the emerging markets index, and between subsectors in the U.S. market. To the last point, we’ve highlighted in the chart below this strengthening correlation in the U.S. of the SP500 versus its key sectors. This outcome of increased correlation is, obviously, increased directional risk, but also increased performance risk, as Alpha becomes increasingly difficult to come by.
Daryl G. Jones
Director of Research