The Dollar and Commodities Break a Long-Standing Pattern
(Bloomberg View) -- As a general rule, there’s an inverse correlation between the value of the U.S. dollar and commodity prices. This pattern holds true more often than not, but we are in a period when this trend has been reversed.
Consider a long-term chart of the S&P GSCI Commodity index, which represents a broad mix of commodity futures, against the U.S. Dollar Index, which tracks the greenback against a basket of the major currency peers. It’s evident that over time, when the dollar moves higher, commodities tend to move lower and vice versa.
The primary reason is that because the U.S. dollar is the reserve currency of the world, it has long been the benchmark pricing mechanism for most commodities. The dollar tends to be the most stable foreign-exchange instrument, so most other nations hold it in the form of reserve assets, making it the exchange mechanism in many, if not most, international transactions for raw materials.
When the value of the dollar falls, other nations have more buying power as it takes less of their currencies to purchase dollars, thus increasing demand for commodities priced in dollars. And because every nation consumes raw materials, commodities are global assets. Finally, the dollar is freely floating, and more liquid than other currencies.
But looking at a shorter-dated chart, it appears that last year this negative correlation started to break down as both commodities and the dollar lost value simultaneously.
Why is this happening? There are four primary reasons.
Trump’s Faltering Revitalization Agenda: President Donald Trump has made little headway on many of the central promises he made during the campaign, including building the Mexico border wall, which would have required large government purchases of raw materials. Trump’s campaign rhetoric was all about infrastructure spending, yet his desire to rebuild America’s roads and bridges hasn’t been fulfilled. And for now it looks as though Trump’s attempts to demolish President Barack Obama’s legacy have been thwarted. He has preserved Obama’s Iran nuclear deal, failed to repeal the Affordable Care Act and couldn’t overhaul the tax code. The fizz from the initial rallies of commodities such as copper and steel has run out, while the strength of the dollar has toppled.
The Renegotiation of Nafta: Trump came into office with the goal of scrapping the North America Free Trade Agreement and imposing import taxes not only on Mexico and Canada but other nations from which the U.S. gets its raw materials. In anticipation, both commodity markets and the dollar rallied, only to falter when the administration could not get the support from Congress. According to Commerce Secretary Wilbur Ross, the administration has chosen to update rather than remove the somewhat antiquated 23-year old agreement and to address issues around digital trade and commerce, among others. Meanwhile, Nafta negotiating objectives require domestic policy changes that Canada and Mexico are likely to side with, as the objectives’ tone is much less protectionist than some feared.
The Equity Bull Market: The stock market hasn’t been this sure of itself since President Bill Clinton first took office. This is evidenced by the VIX, a measure designed to track stock market fear, now at a 24-year low.
Assets continue to drive equity markets to record highs, while exiting havens such as bonds, gold and the dollar. The weakening U.S. currency puts the Federal Reserve in a great position, even as Chair Janet Yellen is raising interest rates and unwinding the balance sheet, both serving to tighten markets. Yet equity investors continue to shrug this off and are not only pushing up valuations on U.S. stocks but seeking opportunities both in Europe and emerging markets beyond the BRICs. Meanwhile there’s still an element of skepticism as to whether future data coming out of the U.S. will be encouraging enough to keep Yellen and the Fed on track to raise rates further, which adds to the pressure on the dollar.
The Clean Economy: Trump refused to sign the Paris accord and has begun to repeal environmental regulations that were imposed in the Obama administration, but these efforts are not stopping the world, nor the U.S. on a state level (California, among others) from realizing and acting on the ramifications of climate change. When the U.S. finally opened its doors to oil exports it was logical to be bullish on oil and the dollar as nations would need greenbacks to import U.S. oil. But the push to drill served to create an oil and gas glut and pressure prices downward, while OPEC cuts were insufficient. The global drive toward increasing production of renewable energy, as well as more efficient production and consumption of raw materials in general, combined with greater emphasis on recycling all serve to push down commodity prices. Investing in clean energy for the second quarter of 2017 reached $64.8 billion globally, up 21 percent from the first quarter and the highest since the second quarter of 2016.
For the time being, the commodity/U.S. dollar positive correlation could persist, but it may succumb to a more normal inverted relationship should Trump finally get some of his infrastructure, tax and other policies enacted or if the Fed (with potentially a new governor) turns more hawkish.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Shelley Goldberg is an investment adviser and environmental sustainability consultant. She has worked as a commodities strategist for Brevan Howard Asset Management and Roubini Global Economics.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
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