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inside the market

Stronger U.S. economic growth would mean higher demand and prices for commodities under normal circumstances, but global markets are stuck in a bizarro world where the reverse is likely true. A stronger U.S. outlook increases the odds of Fed interest rate hikes that, by increasing investment flows into U.S. assets, would depress commodity prices and Canadian dollar.

The first chart below shows the influence of Federal Reserve policy on the value of the U.S. dollar. The orange line represents the futures-implied U.S. central bank interest-rate estimate for the end of 2016. (I used the December Eurodollar contract to calculate this, for readers interested in the methodology.) A rising line indicates greater odds of further U.S. interest rate increases.

The grey line on the chart shows the value of the U.S. trade-weighted dollar index – the value of the greenback versus its major trade partners, including Canada.

Beginning in mid-October, 2015, when the market began taking Fed warnings of impending rate increases seriously, the value of the U.S. dollar climbed along with interest rate expectations, and fell when fewer rate hikes were expected. In early 2016, futures markets provided very early warnings that the potential for interest rate increases would fall sharply, taking the U.S. dollar lower. The relationship between the interest rate forecast and the greenback arises from the fact that historically, higher U.S. central bank rates result in higher Treasury bond yields, which attract foreign capital into Treasuries and push the currency higher.

The second part of current market puzzle is that oil and other commodity prices move in the opposite direction of the U.S. dollar, as the lower chart shows. This is in large part because commodities are priced in dollars, so resource prices automatically drop as the currency strengthens.

From mid-October, 2015, to late January, 2016, when markets were convinced of much higher U.S. central-bank rates, the U.S. dollar index climbed 5.9 per cent while West Texas intermediate crude plummeted 33.5 per cent. After that point, Fed chair Janet Yellen and the rest of the Federal Open Market Committee began voicing caution about the U.S. economic outlook, strongly suggesting that hikes would be delayed. The result was a complete reversal of the previous trend – oil jumped 29.1 per cent and the dollar index dropped 6.4 per cent.

It should be noted that China's economy is playing a large and confusing role in all this. In a recent speech in New York, Ms. Yellen cited global economic concerns, centred in China, as one of the main reasons interest rate hikes have been delayed. Investors are accustomed to thinking of stronger Chinese growth as a positive for commodities, but this may have changed. Economic stability in China makes a Fed interest rate hike and a rising greenback more likely and as we've seen, this will put downward pressure on resource prices.

So what does all this mean? Global investors are faced with a counterintuitive scenario where stronger U.S. and Chinese economies could be a negative factor for commodities and, by extension, the oil-driven loonie.

For me, focusing on the Federal Reserve's interest rate policy is the only way to make the market volatility of the past six months intelligible. When the U.S. economy was improving, the potential for higher interest rates caused significant weakness in commodities, and indeed most higher-risk market sectors (this includes high-yield bond markets and technology stocks). More recently, and somewhat perversely, weaker U.S. and Chinese economic data have eased fears of higher rates and resulted in a "risk-on" equity market rally.

Where markets go from here depends primarily on the U.S. economy. It seems a backward way of looking at things, but strengthening American growth will put Federal Reserve-related fears back in the market, and equities are likely to be weak. Continued economic sluggishness, if current patterns continue, will be positive for risk assets.

Follow Scott Barlow on Twitter @SBarlow_ROB.