In this short article, I will try to explain the relationship between commodity prices and both dollar. We typically see a negative correlation between them, why is that and is this always true?
Relationship between commodity prices and dollar
As I just said, there is a relationship between commodity prices and the dollar. It means that when the dollar weakens against other currencies, commodity prices tend to surge and conversely. Major commodities are traded in USD since it’s the reserve currency of the world, probably the most liquid and because the U.S is a huge importer.
Now, imagine that you are a European firm which has to buy oil barrels. Oil barrel’s price is 50$ on the market and EURUSD is at 1. Therefore you need to spend 50€ to buy a single barrel. 1 month later, the dollar is stronger and EURUSD trades at 0.8 and oil prices have been steady, you now need 62.5€ to buy a single barrel even though its price in USD hasn’t moved. In this case, the demand for oil will decrease, as a consequence, its price will fall down.
How can we monitor the dollar strength? Monitoring EURUSD, for example, will only tell you about its strength against EUR, not its general trend.
The DXY Index is one solution. This is an index that tracks the dollar’s strength against some important currencies with a different weight for each one. Here’s the index component:
And last, how can we monitor the whole commodity price trend? By watching the WTI crude oil prices? Against, there are indices such as the CRB (Commodity Research Bureau) or the Bloomberg Commodity Index.
Let’s see the historical 20-weeks rolling correlation between the DXY index and the CRB index:
Correlation is displayed on the chart at the bottom. We can see that most of the time correlation is negative but it happens that the trend changes (it was recently the case).
The relationship between commodity prices and interest rates?
I read plenty of things about the relationship between interest rates and commodity prices. It’s given that a negative relationship exists between them too for these reasons:
- When short-term interest rates (set by the central banks, see the article on inflation and interest rates) move upward, the cost of financing stockpiles (borrowing cost) is higher and will encourage firms to buy commodities only when needed.
- When short-term interest rates go up, the demand for commodity declines as investors become more interested in higher yield assets.
Therefore, commodity prices should rise when interest rates fall down and vice-versa. But it’s harder to see historically (or at least I didn’t really manage to find it).
The strong negative correlation seems pretty hard to see in reality. Actually, we rather notice an alternative succession of positive and negative correlation. Jeffrey Frankel, a professor at Harvard University, goes deeper in this study in its paper “The Impact of Monetary Policy on Commodity Prices” for those who are interested.
Splitting the CRB Index to see the correlation between each component and interest rates could be a way to see whether or not some commodities are more impacted than others.
We have seen in this article the strong negative relationship between the commodity prices and the dollar. However, this correlation is empirical and isn’t always verified as we have seen before.
Also, it has been harder for me to show the same kind of relationship between commodity prices and interest rates. I think it’s important to remember that there are other important drivers for commodities such as extreme weather events, OPEC decision, world tensions, inflation forecasted…
Share in comments or send me a message on LinkedIn if you have anything to suggest/add to this article!