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King Dollar, Bonds, and Crude Oil

After a very nice, warm, and much-needed vacation, we are back to analyzing global financial markets. It hasn't been that long since our last post, but some of the trends we observed a couple weeks back have really started to take hold.

The most significant trend is undoubtedly the strength of the U.S. Dollar, which is something we repeatedly highlighted in recent weeks. Currency markets are literally the foundation of the global financial system, and they represent the biggest market in the world, with over $5 trillion dollars worth of volume traded daily. The strong bid in the dollar represents capital flowing into the Unites States from around the world. In other words, the dollar continues to appreciate against foreign currencies. It's also on the verge of closing out at its highest weekly level since May 2017, which is hardly a bearish characteristic.

But today we want to focus on the intermarket repercussions for this trend in the currency markets. Think of the dollar as a commodity or an asset class in of itself. A rising dollar usually has a deflationary effect on commodity prices. That is, if the dollar is rising, commodity prices go down because investors would rather own cash over hard assets. The inverse is typically true too. That is, if the dollar is falling, commodity prices go up because investors would rather own hard assets over cash.

The chart of the U.S. Dollar above clearly shows an important bottom was made in early 2018. Now look at the chart below of Crude Oil.

Note that Crude Oil peaked in October 2018, and has struggled since the U.S. Dollar has rallied overall. However, there was a period between February and October 2018 where the dollar and oil rose in tandem with each other. This would be an example of increasing real demand for oil.

Now let's look at a chart of the 10-Year Treasury yield below. Notice how interest rates also peaked in October 2018, and then followed the collapse of Crude Oil. This is a textbook example of how the price of Crude Oil affects inflation expectations, which in turn affects interest rates. This is because interest rates are a function of inflation.

The type of analysis we just performed is an example of intermarket analysis. When it comes to analyzing markets, looking at any asset class from a one-dimensional perspective will seldom work out in one's favor. All assets are tied together in one form or another, and capital flows back and forth between them, much like it does between countries.

So, let's synthesize what we just covered. The U.S. Dollar continues to perform well relative to other currencies. This is mainly because investors are able to obtain higher rates of return on American assets (stocks and bonds) compared to other countries. It's also because the American economy is overall performing much better than other countries, and foreigners want in on the action.

In order to purchase American assets, foreign investors must purchase U.S. Dollars. In doing so, they have essentially created domestic deflation, as the demand for dollars has outweighed the demand for commodities such as Crude Oil.

With Crude Oil prices collapsing, it has translated to lower inflation expectations. This in turn has caused interest rates to fall, since interest rates are a function of inflation.

And voilà, we just completed our intermarket analysis. So long as the U.S. Dollar remains strong, one can generally expect Crude Oil prices and interest rates to remain subdued. There are always exceptions to the rule, but when it comes to markets, guidelines and principles are all we have.

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