Stock selloffs ignite dollar rallies

The inevitable periodic selloffs in the general stock markets indiscriminately hammer all stocks lower. But they pose a special magnified risk to commodities stocks. In addition to weighing on this sector directly, stock selloffs ignite fast US dollar rallies. This rapidly drives dollar-denominated commodities prices lower, amplifying the selling pressure faced by commodities stocks.

The threat of a stock-market selloff is particularly relevant today. The flagship S&P 500 stock index (SPX) is extremely overbought technically, and sentiment is wildly complacent and bullish. Key indicators reflecting traders’ collective psychology are pegged near dangerous levels from where past major SPX selloffs started. Right now the stock markets are as ripe for a major correction as they’ve ever been.

Meanwhile the Continuous Commodity Index (CCI) continues to achieve new all-time record highs, reflecting similar exuberance in the commodities realm. And the benchmark US Dollar Index (USDX, the best proxy for this currency) is relatively low with lots of room to soar. I can’t imagine a more-perfect scenario for an SPX selloff igniting a USDX rally that temporarily crushes commodities prices!

This effective double jeopardy that SPX selloffs exert on commodities stocks offers great opportunity to speculators and investors who understand it. When the risks of an SPX selloff wax high, speculators can realize profits and raise cash to ride out the coming carnage. Then once the SPX selloff passes, both speculators and investors can snatch up the resulting commodities-stock bargains.

The inverse relationship between the US stock markets and US dollar, at least at its present potency, flared up during 2008’s once-in-a-century stock panic. That epic event, far more than anything else in our lifetimes, galvanized traders’ sentiment during stock-market selloffs. Its echoes have been strongly felt in the last couple years, and will continue to reverberate for years to come (with decreasing intensity).

In order to understand how SPX selloffs ignite USDX rallies today, we have to start during that crazy panic episode. This first chart superimposes the USDX (blue) over the SPX (red) for comparison. The inverse correlation between these two datasets is visually-astounding. Major SPX selling episodes are highlighted in red so we can easily see what the US dollar did over these particular spans.

Before the panic, the US Dollar Index hit an all-time closing low back in April 2008. It had fallen a mind-blowing 41% since its secular bear started in July 2001! It is crucial to realize that the dollar started off a very low base before that autumn’s stock panic erupted. By mid-July 2008, the USDX was scraping along just 0.5% above its all-time low. You could hardly even give US dollars away, global investors rightfully spurned them after their long bear.

That month though, a bond panic started brewing. After their stocks plummeted 72% and 78% in a single month, US mortgage giants Fannie Mae and Freddie Mac teetered on the edge of bankruptcy. Large investors around the world who owned trillions of dollars worth of these GSEs’ bonds watched nervously. Would they get their principal back if the GSEs failed? Rather than holding and hoping, they rushed to sell GSE bonds. Some of this capital flooded into US dollars (cash), and some parked in US Treasuries.

As these fears accelerated into a full-blown bond panic, the USDX shot up rapidly. Then just when the dollar peaked and started to roll over in August, the stock panic ignited. This is shaded in red above. Between late August and late November 2008, just 3 months, the flagship S&P 500 stock index plummeted 42.2%! It was an utter bloodbath, unlike anything seen since the Panic of 1907.

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