Why a Strong Dollar is Bearish for Commodities

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The U.S. dollar is the reserve currency for the world. There are reasons that the U.S. currency has this role. The dollar is a liquid currency, perhaps the most liquid in the world. Therefore, it is easy to buy and sell dollars. Central banks around the world hold dollar reserves for this reason. The influence of the United States over past decades has made the country one of the most stable in the world, stability is an important characteristic when it comes to a currency.

Additionally, the U.S. has been and continues to be one of the largest consumer economies in the world. While the U.S. exports certain commodities like corn and soybeans, it is a huge importer of others. As such, the pricing mechanism for most commodities around the world is the currency of the United States of America. When the value of the dollar rises, the price of commodities measured in other currencies rises. When raw material prices rise, demand tends to fall. Conversely, during periods of dollar weakness the price of raw materials tend to fall in other currencies and lower prices tend to increase demand. This is why the dollar has such an important role in influencing the price of commodities.

A long-term bear market in the dollar that began in 2002 corresponded to a secular bull market in commodity prices that commenced at the same time. In 2011, the dollar began a multi-year period of consolidation until it began to climb in value against other currencies in May of 2014.

As the monthly chart illustrates, not only did commodity or raw material prices move higher as the value of the dollar decreased, prices reversed when the descent of the dollar ran out of steam. The secular bull market in commodities reached a peak in 2011 -- copper traded to all-time highs over $4.50 per pound, gold traded over $1900 per ounce, the price of sugar moved to over 36 cents per pound and many other commodity prices responded in the same fashion.

However, starting in 2011 those prices began a long descent.

By May 2014, prices for many staple commodities had already fallen well below all-time highs established during previous years. However, when the dollar began a rally that took the dollar index from lows of 78.93 to highs of over 100 in ten months the commodity sector moved considerably lower. Copper fell to under $2.50 per pound, oil fell from over $107 per barrel in June of 2014 to under $45 by January of 2015 and sugar fell to below 12 cents by March 2015. The vast majority of commodity prices fell dramatically. In the world of commodities, both fundamental and technical factors drive prices. Therefore, each individual raw material has its own set of idiosyncratic characteristics. For example, a shortage in the cattle market coupled with increasing global demand for beef caused prices to remain high. For the most part, however, the stronger dollar caused commodity prices to fall as a whole.

As another specific example of the dollar's influence on the price of commodities, during the first quarter of 2015, the dollar index moved 8.84% higher than where it was at the close of 2014. During the same period, an average of the major commodities that trade on futures markets fell by an average of over 8%.

It is clear that there is a negative correlation between the dollar and commodities. It is probable that this connection will remain intact so long as the dollar is the pricing mechanism for these staples. Therefore, a strong dollar is generally bearish for commodity prices.

It is possible that one day another currency will replace the dollar as the reserve currency of the world. When that happens, it is likely that commodities and that new reserve currency will have the same inverse relationship over time.

The dollar and commodities in 2016 and early 2017

After the rally that took the dollar index over 27% higher from May 2014 through March 2015, the dollar entered a twenty month period of consolidation trading from just below 92-100.60 on the active month dollar index futures contract.

In November 2016, the dollar began another leg higher when it broke above the 100.60 level. Commodity prices had rallied from lows in late 2015 and early 2016 during the consolidation period in the greenback. 

The dollar index traded to a high of 103.815 in early January 2017, the highest level since 2002. As of early March 2017, technical resistance for the index is at 109.75. The dollar rallied as the prospects for higher U.S. short and long-term interest rates have increased the yield differentials between the U.S. currency and other major foreign exchange instruments around the world. Given the long-term inverse historical relationship between the dollar and commodity prices, it is possible that the recovery in raw material values could run into some trouble if the dollar continues to appreciate throughout 2017. Moreover, higher real interest rates tend to be a bearish factor when it comes to commodity prices as it makes the cost of carrying raw material inventories higher.

While each commodity has its individual supply and demand characteristics that ultimately determine the path of least resistance for prices and inflationary pressures tend to be supportive for commodities, higher rates, and a strong dollar could slow down any future appreciation in commodities. When conducting analysis on commodity prices always remember to watch the technical and fundamental position of the dollar as it can provide important clues for the price direction of the overall commodities sector.