Are commodities bottoming out?

The world is still obsessed with the prospect of Chinese weakness, Fed tightening, collapsing commodity prices and super-low oil prices, all of which might—or so the thinking goes—tip us into a deflationary downward spiral. When a narrative such as this becomes so widespread, it's easy to miss important clues to the contrary. I note here a few contra-indicators which bear watching:

The first chart above shows a short-term view of the CRB Raw Industrials commodity index, while the second gives you the long-term view of the same index. This index is composed of some pretty mundane commodities (hides, tallow, copper scrap, lead scrap, steel scrap, since, tin, burlap, cotton, print cloth, wool tops, rosin, rubbers), most of which do not have associated futures contracts and are therefore relatively immune to speculative forces and thus more likely to reflect the changing balance between supply and demand. Since late November, the index is up more than 5%—after tumbling more than one-third from its early-2011 high. As the second chart shows, the plunge in recent years is similar—if not greater—in magnitude to other plunges, all of which were followed by reversals to the upside. Maybe the Great Commodity Price Collapse has come to an end?

As the chart above suggests. Commodities have a strong tendency to move inversely to the dollar's value vis a vis other currencies (note that the y-axis for the dollar is inverted). It might be the case that the dollar is topping out here, just as commodity prices bottom out. [Update: the original chart was mislabeled, now corrected with data as of Feb 3]

This index (see chart above) of the dollar's value against a small basket of major currencies shows that the dollar has been flat for almost a year, another indication the dollar is topping out.

What could be the impetus for the dollar to stop rising? Simple: the perception that the U.S. economy is weak and that therefore the Fed is unlikely to raise rates aggressively. Indeed, I think that process is already underway. Since June of last year, March '18 Eurodollar futures (tied to 3-mo. Libor) have fallen from 2.4% to 1.2%. The market was expecting at least four tightenings by the Fed and now it is only expecting two more over the next two years. With the greatly-reduced prospect of higher short-term rates (and less-than-previously-expected Fed tightening), the dollar is losing some of its appeal.

So, whatever it is that is slowing down the U.S. economy is also reducing the appeal of the dollar, and that in turn is helping to put a floor under commodity prices. And the end of declining commodity prices—particularly if this includes oil—should help alleviate fears of a deflationary death spiral. Markets have a way of resolving things if left to their own devices.

This is not a call for shorting the dollar or going long commodities. It should be taken more as a note of caution that the prevailing wisdom may be getting long in the tooth, and changes may be waiting in the wings.

UPDATE (Feb 3): Well, this change seems to be unfolding all of a sudden. The market senses that the economy is weak, and that therefore the Fed is unlikely to raise rates aggressively. That directly undermines the value of the dollar, which had been boosted by the perception that the US economy was doing much better than others, and that the Fed would be boosting rates. A weaker dollar (which  today is on track for its biggest drop in seven years) provides support to commodity prices, and that is showing up in a huge increase (7-8%) in oil prices today. The stock market is breathing a sigh of relief, as the threat of tight money recedes and higher oil prices reduce the risks of widespread bankruptcies in  the oil patch.