The Fed, USD, & The Price of Commodities

Historically there has been an inverse correlation between the strength of the US Dollar (USD) and commodity prices. Commodities such as metals are priced in USD so when the USD appreciates against other global currencies, commodities become more comparatively more expensive for buyers in other countries.

For example, if copper was trading at $9,000/mt, but someone was using Euros (EUR), they would first have to convert EUR to USD in order to pay. If the EUR/USD rate is 1.08, then copper in EUR terms is trading at EUR 8,333/mt. If that rate changed to 1.06, but the LME copper price remained at $9,000, that same copper now costs EUR 8,491/mt, an increase of EUR 158/mt. This is a significant change for any company transacting in EUR. If this impact is significant enough to decrease global demand, then the copper price (and other commodity prices) would decrease to a point where demand stabilized. 

The opposite is true if the USD weakens. In the above example, the EUR/USD rate moved from 1.08 to 1.06. If instead, it increased to 1.10, that same $9,000/mt copper would now cost EUR 8,182/mt, a decrease of EUR 151/mt. This decrease in comparative cost for global buyers using other currencies could be significant enough to increase demand and the price of copper (and other commodities) would increase to a point where demand stabilized.

This is a very high-level and simplistic view but it is important to understand the historical context and why metal markets pay such close attention to things like the FED interest rate decisions.

Now the FED have entered a cycle of lowering interest rates, the argument goes that the USD should continue to weaken. As interest rates are lowered, the yield on US bonds decreases, making them less attractive to foreign investors. This in turn decreases demand for USD, and the dollar weakens. But alongside the outright cost of the commodity in other currencies, there are several other factors to consider:

Because global demand is such a complex and interconnected picture, a weakening USD does not guarantee higher commodity prices (or vice versa with a strengthening dollar). If the market believes that the FED is being forced into large rate cuts because the US is headed for recession (along with other global economies), that may actually have an offsetting or even larger negative impact on global demand for commodities. Hence, we may see prices head lower in the near term - though like most reactions to news announcements, the initial responses are likely to be knee-jerk rather than well-thought-out long-term decisions.

A declining dollar can also have inflationary pressures. The FED has spent the last two years trying to bring down inflation down so if demand within the economy starts to heat up and prices start to rise, they may not be as quick to bring down rates as some are expecting in order to keep inflation levels where they need to be.

A weaker dollar can also see investors trying to diversify their portfolios and commodities are often seen as a hedge against inflation and currency depreciation. Any increased investment from the speculative community can see upward pressure on commodity prices (as we have seen recently with gold reaching all-time highs). 

A weaker dollar can also serve as a catalyst in emerging economies to increase their demand for commodities. A weaker dollar means significant infrastructure projects become relatively cheaper and governments or private investors may use these periods of dollar weakness to step up commodity purchasing, increasing global demand further. However, markets are forward looking and prices can be very quick to react so the other side to this coin is that upward pressure on prices actually exceeds the benefits of a stronger local currency, leading to planned projects being put on hold, and not having the impact on demand that one might assume.

There is also the ever real threat that as US debt continues to mount, and other countries like BRICS grow weary of the US's global influence over money supply, there will be global pressure to find a new settlement currency and that commodities eventually use a different currency for their pricing base. If this happens then the historical links between the USD and commodities prices will enter a new paradigm where their correlation will be entirely unknown.

Whatever the short, medium, and long-term ramifications of FED rate policy are, along with other central banks and whether we are headed for soft landings, hard landings, or I even heard the phrase ‘no landing’ thrown about on CNBC today, the importance of fully understanding hedging and mitigating price risks is more important than ever as volatility is likely to remain for the foreseeable future.