How the Dollar Impacts Commodity Prices

Topic Images Inc./Getty Images

Typically, there is an inverse relationship between the value of the dollar and commodity prices. When the dollar strengthens against other major currencies, the prices of commodities tend to drop. When the value of the dollar weakens against other major currencies, the prices of commodities generally move higher. This is a general rule but it holds true more often than not over time.

If you look at a chart of the CRB index which contains a diverse group of commodity prices against a chart of the dollar index which represents the strength or weakness of the U.S. currency against other foreign exchange instruments, you will notice that, as a general rule, when the dollar moves higher, commodities tend to move lower.

The converse occurs as the dollar moves lower. The correlation is not perfect, but over time there is a significant inverse relationship.

There are many reasons why the value of the dollar influences commodities prices. The primary reason is that the dollar is the benchmark pricing mechanism for most commodities because the U.S. currency is the reserve currency of the world. The dollar tends to be the most stable foreign exchange instrument so most other nations hold dollars as reserve assets. Therefore, when it comes to international trade for raw materials, the dollar is the exchange mechanism in many, if not most cases. When the value of the dollar drops, it costs more dollars to buy commodities.At the same time, it costs a lesser amount of other currencies when the dollar in moving lower. 

Another reason is that commodities are global assets, they trade all over the world. Foreign buyers purchase U.S.commodities such as corn, soybeans, wheat, oil, and others with dollars.

When the value of the dollar drops, they will have more buying power as it takes less of their currencies to purchase a dollar. Classic economics teaches that demand typically increases as prices drop.

Commodity traders need to keep a close eye on the value of the dollar. One of the best ways to monitor the dollar is to watch the price quotes of the Dollar Index traded on the ICE Futures Exchange.

This futures contract is an index that values the dollar against a group of other major currencies around the world like the euro, yen, British pound, and other foreign exchange instruments. The price of the index is traded like any other futures contract and moves up and down during trading hours.

Commodity prices don’t necessarily tick higher for every tick lower in the Dollar Index, but there is a strong inverse relationship over the long-haul. Individual commodities have fundamental supply and demand characteristics so they move one way or another at times despite the direction of the U.S. currency.

The dollar is the benchmark because it is stable

Commodity prices do not trade in a vacuum. Commodity production is often a localized affair. As an example, the majority of corn and soybean production in the world comes from the fertile lands of the United States. The mineral rich soil of Chile yields the largest output of copper on earth and half the world’s oil reserves are located in the Middle East. The largest producers of cocoa beans are located in Africa in the Ivory Coast and Ghana. As you can see, commodity production depends on climate and geology in specific locations. However, consumption of these important raw materials that are staples for all humans occurs all over the globe.

When it comes to the price of commodities, the vast majority of these raw materials use the dollar as a pricing mechanism for global trade. That is because the U.S. is the strongest and most stable economy in the world. Therefore, the dollar is the reserve currency of the world and the pricing mechanism for commodities. When the dollar strengthens, it means that commodities become more expensive in other non-dollar currencies. This tends to have a negative influence on demand. Conversely, when the dollar weakens, commodity prices in other currencies move lower which increases demand.

Each commodity has idiosyncratic characteristics. However, the value of the dollar has a direct influence on the prices of all commodities. In May 2014, the dollar began to strengthen. During the month, the U.S. dollar index traded to 78.93 on the active month futures contract.

In early March 2016, that dollar index was trading around the 97 level – the dollar had appreciated by around 23% over less than a two year period. Many commodity prices moved lower over this period. This is the perfect example of the inverse relationship between the value of the dollar and commodity prices.Historical relationships serve as a guide as history tends to repeat itself. However, there are times when major divergences occur so it is possible that commodities prices and the dollar can move in the same direction at times.