The recent appreciation in the US dollar has been a key factor behind the weakness in overall commodity prices over the past couple months. To recap looser monetary policy (one aspect of which could include lower interest rates but also printing money) reduces the cost of storing commodities and thereby increases the demand to hold them. Lower interest rates may also incentivise investor’s to put their money into riskier assets like commodities rather than bonds or equities. Finally, looser monetary policy could also mean that investor’s cash is channeled towards investments in emerging economies that will then indirectly result in an increase in demand for commodities. All of these factors work in reverse when considering a tightening in US monetary policy.
As the chart below shows while the US Dollar Index has strengthened to the highest level for almost one year the CRB Commodity Index is down 6% since late June, giving up almost all the gains made during 2014. With the US Fed due to end quantitative easing by October the next stage towards normalization of US monetary policy will be higher interest rates.
Back in December we highlighted research from ANZ bank which suggested that Chinese demand would be the key determinant of commodity price direction during 2014. The bank thought that the headwind from a stronger dollar was already priced in and that instead commodity buyers and investors should look at Chinese equity markets for clues as to the future direction of commodity prices. ANZ noting that while the relationship between US equity markets and commodity prices has broken down over the past few years, it has re-engaged between Chinese equity markets and commodities. As it turns out the Chinese equity market has been a poor indicator of overall commodity price direction. While weather related factors largely caused many commodity prices to rise at the beginning of the year, more recently commodity prices have declined just as the Chinese stock market has rebounded.
Related article: Chinese demand key to commodity prices in 2014
Looking back, although Chinese demand has a key factor in determining commodity prices the evidence over the past ten years suggests dollar weakness has been a much stronger factor determining commodity prices. In the chart below the red line plots the 10-year rolling correlation of annual returns on the CRB commodity index with China’s real GDP growth. The correlation between these two numbers has stayed close to 0.4 since the late 1990’s. Now take a look at the blue line, which shows a negative correlation between the CRB and the US Dollar Index. The correlation since 2010 has hovered around -0.8, implying that the dollar has much more explanatory power.
In terms of an increase in the short-term federal funds rate the moment of reckoning could be as early as the middle of 2015 even though Fed Chairwomen Janet Yellen indicated in her most recent statement that she is quite prepared to continue to keep interest rates very low levels. Nevertheless the direction of travel is clearly towards a tightening in US monetary policy (Goldman Sachs forecasts interest rates will rise to 4% by 2018) and a stronger US dollar. Not all commodities will be affected equally however with precious metal prices in particular likely to remain subdued.