How the Dollar Impacts Commodity Prices
The general rules might be changing
There's normally an inverse relationship between the value of the dollar and commodity prices. The prices of commodities have historically tended to drop when the dollar strengthens against other major currencies, and when the value of the dollar weakens against other major currencies, the prices of commodities generally move higher. This is a general rule and the correlation isn't perfect, but there's often a significant inverse relationship over time.
If you look at a chart of the CRB index, it includes a diverse group of commodity prices against a chart of the dollar index. This represents the strength or weakness of the U.S. currency against other foreign exchange instruments.
Why the Movement?
The primary reason the value of the dollar influences commodities prices is that the dollar is the benchmark pricing mechanism for most commodities. 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.
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 is moving lower.
Commodities Are Global Assets
Another reason for the influence of the dollar is that commodities are global assets. They trade all over the world. Foreign buyers purchase U.S. commodities such as corn, soybeans, wheat, and oil with dollars. When the value of the dollar drops, they have more buying power because it requires less of their currencies to purchase each dollar. Classic economics teaches that demand typically increases as prices drop.
The Dollar Is the Benchmark Because It's Stable
Commodities don't trade in a vacuum. Commodity production is often a localized affair. The majority of corn and soybean production in the world comes from the fertile lands of the U.S. 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 in Africa in the Ivory Coast and Ghana regions.
As you can see, commodity production depends on climate and geology in specific locations. But consumption of these important raw materials occurs all over the globe.
The vast majority of these materials use the dollar as a pricing mechanism for global trade because the U.S. is the strongest and most stable economy in the world. When the dollar strengthens, it means that commodities become more expensive in other, nondollar 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.
The Effect on Commodities
Each commodity has idiosyncratic characteristics, but the value of the dollar has historically had a direct influence on the prices of all commodities. When the dollar began to strengthen in May 2014, 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 percent in less than two years.
Many commodity prices moved lower over this period—a perfect example of the inverse relationship between the value of the dollar and commodity prices. Historical relationships can serve as a guide because history tends to repeat itself, but there are times when major divergences occur so it's possible that commodities prices and the dollar can occasionally move in the same direction.
Is Change in the Air?
Citi Research reported in March 2017 that the correlation between the dollar and commodity prices became less significant after the dollar index was trading at about 97 just a year before. Specifically, commodities were strong in the latter half of 2016 even as the U.S. dollar gained against other currencies. It was the most significant variation in the correlation a decade. Citi has indicated that this state of affairs might last for a while.
Monitoring the Dollar
One of the best ways to hedge against change and to keep a close eye on the value of the dollar and its correlation with commodities is to watch the price quotes of the Dollar Index. This index is 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, including the euro, the yen, and the British pound. The price of the index is traded like any other futures contract, and it moves up and down during trading hours.
Commodity prices don’t necessarily tick higher for every tick lower in the Dollar Index, but there's often been 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 regardless of the direction of U.S. currency. Risk aversion plays a part, particularly in recent events. Keep your eye on the situation and don't take previous trends for granted.