The US Dollar Index (a measure of the value of the $ against a basket of foreign currencies) hit an 11 year high last week, having seen its biggest 1 year rally since 1985. What are the implications for commodity prices?
But first, underpinning the surging dollar has been the dramatic shift in the pendulum of market expectations over future policy from the US Federal Reserve. The most recent US employment data exceeded expectations with February being the twelfth straight month payrolls have increased by at least 200,000, the best run since March 1995. The odds of a rate increase in September, implied by futures markets rose from 49% to 60% after the jobs data was published. Remember that the US dollar reflects expectations over future monetary policy in the US and its performance relative to its competitors.
Tighter monetary policy, implying a stronger US dollar, can affect commodities in a variety of different ways. First, it increases the cost of storing commodities and thereby decreases the demand to hold them. Second, higher interest rates may reduce investor’s appetite for riskier assets like commodities. Third, higher interest rates may also encourage commodity extraction by increasing the value of monetizing undeveloped commodity resources on the part of producers. Finally, a strong dollar can reduce demand from buyers in other currencies while also encouraging higher production.
The result, the Bloomberg Commodity Index is currently trading near a 12 year low. Note that I’m not for one minute saying that demand and supply fundamentals aren’t also important.
Not all commodities are affected by movements in the US dollar in the same way though. Those commodities where the market is domestic to the U.S. with little scope for transportation outside of North America, for example natural gas and cattle are likely to see very little impact from currency movements. In agricultural markets, a stronger dollar could keep grain prices under pressure, but not in a formulaic way. The costs of farmers outside the US are often borne in local currencies, so the depreciation of the Russian rouble or Brazilian real against the US dollar can increase their incomes.
Are we close to a turning point? It seems unlikely. Well while the dollar has strengthened sharply the middle of last year, this is from very depressed levels and it is still below the historical average. Foreign exchange markets, much like oil prices are trending in a big way, after many range-bound years. As Goldman Sachs describe in a recent note this change is difficult to embrace with investors only updating our perception of the world gradually. Although there will clearly be corrections the implication is that the strength of the US dollar and the weakness of commodity prices represent not the beginning of the end, but the end of the beginning.