What Does a Strong U.S. Dollar Mean for Commodity Prices?

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The currency of the United States of America has made a statement since May 2014. The U.S. dollar index, a measure of the dollar versus other major currencies of the world appreciated from under 80 to over 98 over a less than ​a two-year period. While the bulk of the rally in the dollar occurred between May 2014 and March 2015 and the dollar has entered a consolidation phase, it has remained close to recent highs at just over 100.

There are many reasons that the dollar has appreciated over recent months. The U.S. economy is still the largest in the world. Despite demographics, the U.S. remains the strongest economic nation in the world. The U.S. remains a powerful nation even though less than five percent of the world's population live within U.S. borders. The dollar is the reserve currency of the world. Many other nations hold dollars as a key part of their reserves due to the political and economic stability in the United States. Dollar strength has been the result of moderate growth in the U.S. economy. While European growth remains lethargic, the nation that experienced the highest degree of growth in recent years, China, has seen its growth rate slow. The Chinese economic has shifted from heavy manufacturing to a consumer based economy. As the size of the Chinese economy swells, it becomes harder to grow on a percentage basis as it has in the past.

Think of it this way, it is easier to make a seven percent return on one million dollars than it is to make a commensurate return on one trillion dollars. The sheer size of the Chinese economy makes the percentage growth rate seen in years past almost impossible to sustain. Therefore, Chinese economic growth has slowed on a percentage basis.

Relative strength of the U.S. economy, when compared to those of Europe and China, is a positive factor for the dollar.

A bear market in commodity prices has also been supportive for the dollar. The U.S. is a major consumer of raw materials and lower prices amount to stimulus for the American economy. At the same time, the currencies of nations that depend on commodity revenues have suffered because of lower prices. Canada, Australia, Brazil, Russia, South Africa as well as other commodity producing nations have seen their currency values depreciate alongside raw material prices.

Another positive influence for the dollar is the relative rate of interest paid on the U.S. currency when compared to other currencies. For the first time in nine years, the U.S. central bank raised short-term interest rates in the United States in December 2015. The Federal Reserve also stated their intention that rates will continue to head higher in the months and years ahead. Short-term interest rates in the U.S. went to zero in the aftermath of the housing and global financial crisis in 2008. Growth in the U.S. economy no longer supports such accommodative monetary policy. As the dollar has offered the opportunity for capital growth, in terms of its appreciation versus other currencies since May 2014, higher interest rates add additional support in that they increase the yield on the currency for holders.

Currencies are generally less volatile than other asset classes. This is because central banks and monetary authorities around the world manage their path. The mission of central banks is smooth and stable markets. It is in the currency markets that they generally have the greatest degree of influence, as interest rates are a key determinate of relative currency values. Given current central bank policy around the globe, the prospects are for a continuation of the rise of the dollar. Strong supply and demand underpinnings continue to provide a solid fundamental case for dollar strength.

The historical inverse relationship between the dollar and commodity prices, therefore, should mean that the downside pressure on commodity prices should continue in the months ahead. When commodity prices eventually hit a level where production decreases and inventories decline, commodity prices will find a bottom and can recover.

Considering that raw material prices remain at much higher nominal levels than in 2000, there is likely more downside room for commodities. The dollar is strong for a myriad of reasons and it is likely that it will move even higher in the months ahead. Commodities are entering the fifth year of a secular bear market. Given the fact that commodities tend to be more volatile than currencies, we could see lots of two-way action in energy, base metals, precious metals and agricultural markets in the months ahead. However, it is also likely that we will see a continuation of lower highs and lower lows in the commodity sector until the dollar finds a top and commodities find a bottom.