The U.S. dollar is rising… and that could mean trouble for commodity prices.
Let me explain…
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How to tell what the U.S. dollar is doing
The best indicator for the U.S. dollar is the U.S. dollar index (symbol DXY in the U.S. ICE Futures Exchange).
The DXY measures the value of the U.S. dollar relative to a basket of foreign currencies, which are made up of the euro (57.6 percent), the Japanese yen (13.6 percent), the British pound sterling (11.9 percent), the Canadian dollar (9.1 percent), the Swedish krona (4.2 percent) and the Swiss franc (3.6 percent).
Since January of this year, DXY (as shown in the chart above) is up 3.5 percent in nominal effect terms, which doesn’t factor in inflation. A rising number indicates a strengthening U.S. dollar versus the basket of other major currencies, while a falling number indicates a weakening U.S. dollar.
Not only is DXY up since January, but it’s gained a significant 8.2 percent from its lows of the year set in February.
For people living in a U.S. dollar-based economy (besides the U.S., there are nine other countries that use the U.S. dollar exclusively in their economy), that’s a good thing. A stronger currency makes imports cheaper to buy – everything from washing machines to silver, and the raw materials required to fuel the economy.
But as I said, a rising dollar is usually bad news for commodities prices.
The U.S. dollar’s relationship to commodities
Throughout history, the dollar has had an inverse relationship with commodities. That means that when the dollar falls, prices of commodities – particularly hard commodities that are drilled and mined from the earth like oil, gold and silver – tend to rise.
On average, since 1980, when the dollar has fallen, it has fallen 2 percent. During those months, gold prices have risen 1.3 percent, silver prices increased 1.1 percent and oil prices went up 1.7 percent. The average of a basket of hard commodities (that include gold, silver, oil, platinum, palladium, copper, aluminium, nickel, zinc, tin and lead) gained 0.9 percent.
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And when the U.S. dollar rises, commodities prices fall.
On average, since 1980, when the dollar has risen, it’s gone up by 2 percent. And in those months, gold prices have fallen by 1.1 percent, silver prices have fallen 1.3 percent and oil prices have fallen 1.2 percent. The overall basket of commodities saw their average price fall by 0.7 percent during periods of a rising U.S. dollar.
The main reason for this negative correlation – that is, commodities prices falling when the dollar rises, and vice versa – is because the dollar price of commodities moves inversely with the dollar’s nominal exchange rate.
You see, most (if not all) of the world’s commodities (oil, iron ore, coal, wheat, cotton, rubber, etc.) are priced in U.S. dollars. The producers of these commodities base their selling price on their local currency’s converted equivalent of U.S. dollars. So when the dollar rises, it costs fewer dollars to buy commodities, and when the dollar falls it costs more dollars to buy commodities.
For example, most of the world’s gold, silver and oil are produced in non-U.S.-dollar based economies. The world’s top three gold producers are China, Australia and Russia. These countries all produce gold at a cost in local currency terms (i.e. Chinese yuan, Aussie dollar or Russian rouble).
When the U.S. dollar appreciates, it takes fewer U.S. dollars for producers in these countries to generate the same amount of revenues in local currency terms.
So with the dollar up 3.5 percent since January, we’ve seen commodities prices fall.
For example, gold is down 10.8 percent since January, while silver is down 16.1 percent. Oil is up 21.7 percent, despite the dollar – largely because of supply shortages from production cutbacks by OPEC (the Organisation of the Petroleum Exporting Countries) members, which we wrote about here.
Falling commodities prices hurt most emerging markets
Emerging markets as a whole are exporters of commodities (with the exception of China, India and Turkey).
Indonesia is one example. Its five biggest exports are all commodities that are priced in U.S. dollars. These include palm oil, coal, natural gas, copper and gold. It’s the same for Brazil, where the top three exports are iron ore, raw sugar and crude oil.
So falling commodity prices has a big impact on their economies.
A rising U.S. dollar is also bad news for emerging markets that are net importers of goods and raw materials – like, for example, Greece, Pakistan and the Philippines.
These economies do not earn U.S. dollars. Instead, they need to keep buying dollars from the market using their local currency to pay for their import needs. The higher the dollar rises, the bigger the bill they have to foot in local currency terms.
So as long as the dollar is moving higher, expect commodities prices – and many emerging markets – to continue to underperform.
Publisher, Stansberry Churchouse Research