Commodity prices, China and the US dollar

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.

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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

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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

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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.

Brent slumps to 4-month low

Brent crude prices tumbled below $106 per barrel today (Wednesday 30 July), the lowest level for almost four months. Despite geopolitical concerns continuing to mount up (Israel, Russia, Iraq and Libya), actual physical crude markets appear to be oversupplied, pressuring Brent crude prices . Although the latest set of sanctions (due to be published in detail on Thursday) are unlikely to result in Russia responding by curtailing its oil exports (the country just being too dependent on their sale for revenue) the spat with Russia could begin to affect economic growth in Europe, reducing demand for oil.

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Related article: Oil supply outages are becoming more common and difficult to predict

Rally in base metal prices just a bump in commodity super cycle

How’s this for a stream of counter cyclical indicators? First, this week the Metals and Minerals Investment Conference announced that they would be cancelling the event indefinitely due to current challenging conditions in metal market. Meanwhile Credit Suisse announced that they would be pulling out of commodities trading, following a number of their peers including Deutsche Bank, JPMorgan and Barclays who also said they are either scaling back or exiting the commodities arena.

When the last bulls in town (be it investment conference organisers or investment banks) have folded it could mean that a major turning point is close. Banks from Citigroup to Deutsche Bank have called an end to the commodities super-cycle over the past couple years. The most recent being Goldman Sachs who warned in its report Emerging Market Forex and the End of the Commodity Market Super-Cycle that rising supply over the next five years would hit commodity prices (see table below).

In sharp contrast to the pessimistic outlook suggested by investment conference organisers and investment banks, industrial metal prices have surged in recent months. First, nickel prices are up almost 40% this year due to an export ban in Indonesia. Meanwhile zinc and aluminium prices have surged to three year and 17-month highs respectively as earlier low prices forced producers to cut output, reducing stock levels and fueling the latest rally. Efforts by producers to capitalise on recent higher prices has faltered as new projects are delayed and existing capacity fails to return to production quick enough. Finally signs that Chinese economic growth have stabilised have also supported investor confidence in industrial metals.

So has the commodity super cycle turned and we are now on the next upswing? Looking at recent trends the bull run in nickel prices may have run its course now as a new government in Indonesia appears to be signalling that it could row back on its ore export ban. Signs that Chinese physical demand for commodities may be stabilising may also prove illusory. The Baltic Dry Index (the cost of transporting commodities like iron ore) has fallen to 18-month lows and had its worst July since 1986. Although activity in the manufacturing sector has stabilised (hitting an 18-month high in July) activity in the construction sector (key to demand for industrial metals and in particular copper) remains weak and could deteriorate further over the next couple years.

Perhaps key to commodity prices over the next few years is what happens with oil prices. Energy being a key input into the production and transportation of commodities. Without the recent escalation in oil disruption (both real and perceived) oil prices would be significantly lower given the growth in US oil production. This trend of high oil prices is likely to continue, supporting commodity prices at higher levels than they would be otherwise.

Commodity super cycles are not like stock market crashes. There isn’t a rapid escalation in prices followed a crash before the upward trend resumes. Commodity super cycles have tended to be characterised by cycles lasting 10 years on the upswing followed by 20 years of declines as excess investment leads to a flood of supply. This downward slide is going to be bumpy.

Related article: The half time score for commodity prices in 2014

Related article: Chart: Where we are in the commodity super-cycle

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