Although every commodity has distinct trading characteristics and market movements, investors have historically found a strong correlation between the greenback and commodity prices. Typically, there exists an inverse relationship between the two asset classes, where a rise in value of the US Dollar leads to a fall in commodity prices and vice versa.
While this inverse relationship with the US Dollar holds true for most physical commodities, the degree of dependence varies among individual commodities, since there are some other factors that could weaken the effect of currency movements. The influence of change in weather patterns, infrastructure and supply-chain issues, as well as the easy substitution of one type of commodity for another, all play a role in offsetting the impact of the USD on commodity prices.
For example, the price of WTI crude oil, usually quoted in US Dollars, has lesser number of substitutes, is easily transported and sees constant overall demand. Thus, it has shown a strong link with Dollar performance. On the other hand, commodities like corn, that are influenced by seasonality, have an increased number of substitutes and are easily affected by weather conditions, show little relationship with the US Dollar.
Since the beginning of the 21st century, international commodity prices have witnessed dramatic fluctuations, in terms of magnitude and frequency. These changes cannot be understood only by considering supply and demand factors. This has led to the study of other fundamentals that can affect their values.
Since the US Dollar is the benchmark pricing and settlement currency for commodities trading, its value impacts commodity prices.
The US Dollar is the world’s reserve currency and the most stable foreign exchange instrument, which is why most countries hold it as their reserve asset. While the United States itself exports certain commodities, like soybeans and corn, it is an overall net importer. Therefore, the pricing mechanism of most commodities in the world has been set in US Dollars. Two major factors have been identified for the close relationship between the US Dollar and commodity prices.
Firstly, real assets have intrinsic value and this intrinsic value is expressed in US Dollar terms. Major commodities are priced in USD, and with appreciation in the Dollar value, lesser amount of USD is needed to purchase a commodity, which results in a decline in its value.
Secondly, commodities are global assets, and many of them are vital raw materials for economies to prosper. While commodity production is a localised affair, people and companies that want these raw materials are situated worldwide. When the US Dollar depreciates, the purchasing power of global investors increases, since this translates into a lesser amount of the domestic currency needed to purchase USD. Dollar-priced exports of US-based commodities become less competitive in the global markets. Due to this, dollar-based prices need to fall to match the effective price of global competitors in non-dollar currencies. This drives demand.
Before the 2008 crisis, there was little to no relationship between the US Dollar value and commodity prices. From June 1989 to January 1991, USD bear markets coincided with a sharp decline in commodity prices. Even in the recovery period, after the bursting of the dotcom bubble, from 2003-2006, the relationship between the USD and the commodities market was very weak.
Post 2008, the United States adopted a systematic quantitative easing programme, following which, commodity prices started to rise. Studies have indicated that loose monetary policies drive commodity prices up, and vice versa. From 2011 onwards, the USD started on a path of multi-year consolidation till 2014, when it started to climb in value. During this period, we saw a secular bull market for commodities, with gold trading over $1,900 per ounce and copper trading at an all-time high of $4.50 per pound in 2011. By May 2014, almost all commodity prices fell one after another. By January 2015, oil prices had declined to under $45 per barrel, from $107 per barrel in June 2014.
In November 2016, the US Presidential elections gave a boost to the US economy, with the Dollar index trading at 103.815 in January 2017. Higher real interest rates in the US increased the cost of carrying raw material inventories. This caused a decline in commodity values. Increased USD strength coincided with a dramatic sell-off in commodities worldwide.
Dollar strength continued until late 2018, following which a global economic slowdown appeared to set in. Brexit and the US-China trade war negatively impacted the US Dollar. The slashing of interest rates in early 2019 added to its woes. After a drop in late 2018, oil prices increased steadily since the start of 2019, due to production cuts by the OPEC and its partners.
However, fluctuations in commodity prices in the second half of 2019 have mostly been attributed to the weaker-than-expected global growth outlook. According to the World Bank, the global commodity price cycle is coming to an end, which while bad for exporters, could offer opportunities for importers. Agricultural prices are predicted to fall 2.6%, and crude oil prices are forecasted to average $66 a barrel in 2019.
It is mostly the energy and industry-related commodities, used globally and quoted in US Dollars, that show the strongest correlation.
Nevertheless, historically we have seen plenty of evidence of a relationship between global commodity prices and the value of USD. At least a portion of the steep fall in commodity indices in recent years has been linked to the US Dollar bull market. This is why, for commodity traders, it is useful to keep track of the Dollar index.
Commodity traders often keep a close track of the Dollar index. This index tracks the value of the US Dollar, relative to a basket of foreign currencies. Generally, the index goes up when the USD gains with respect to other currencies. The Dollar index is an important indicator of US economic activity, as well as other activities that can weaken or strengthen the US Dollar.
Commodity prices don’t generally go higher for every lower tick in the Dollar index, this happens over time. As mentioned earlier, a number of other factors can considerably offset the impact of the Dollar dominance on commodity prices.
The current dovish stance by the US Federal Reserve could lead to a downturn in the Dollar value in the future. A fragile US economy could motivate investors to put their money elsewhere, leading to a further decrease in the Dollar value. At the same time, economies reliant on commodity exports could benefit from increased commodity prices.