Pramod Thomas | Mar 14, 2018 | 0
Impact of Currencies on commodity price
By Anil Mishra
Commodities are global in terms of consumption but are localized in terms of production, depending on the climate and geology of that particular area which is endowed with the natural resources. They are traded globally but need to be traded in most acceptable global currency. US Dollar is the most acceptable currency hence most of the commodities are traded in US Dollar.
Why commodities trade in US Dollar?
The U.S. dollar is the reserve currency of the world because it is 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.
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 Rubber is produced in Asian countries like Thailand, Malaysia, and Indonesia. Corn and soybean come mainly from the United States. Chile produces the largest amount of copper; almost half of the world’s crude oil reserves are located in the Middle East. The largest producer of coffee is Brazil and cocoa beans are produced 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 is 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.
Impact of strong Dollar on commodity price
Each commodity has its own 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.
Inverse relationship between Dollar and commodity price
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.
The chart illustrates the inverse relationship over time when US Dollar Index surges commodity price index plunges and vice versa.
But this negative correlation between the USD and commodities is not as simple or as binary as it seems. After the 2008 financial crisis, the inverse relationship between the USD and commodities was particularly strong, while before that time, it was more difficult to establish this kind of relationship.
According to a Bloomberg survey conducted over the period 1990-2015, nearly 60% of the time the negative correlation between the USD and commodities existed. In nearly 40% of the time, there was a positive correlation, with around 23% of this 40% describing a situation of an increase in both USD and commodities prices, and around 16% of the 40% describing a situation of a drop in the USD and commodities.
Why the value of the dollar influences commodities prices?
There are many reasons for this. The primary reason is that the dollar is the benchmark pricing mechanism for most commodities. When the value of the dollar drops, it costs more dollars to buy commodities, hence commodity price goes up dollar terms. 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 commodities such as Rubber, coffee, corn, soybeans, wheat, oil etc with dollars. When the value of the dollar drops, the buyers of other currencies will have more buying power as it takes less of their currencies to purchase a dollar.
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 their own fundamental supply and demand characteristics so they move one way or another at times despite the direction of the US currency.