A New Commodity Bull Market Must Come With a Weak US Dollar

Pricing commodities in US Dollars ensures that the three factors mentioned above are all reflections of the trend in commodity markets. Growth differentials are due to commodity strength, which flows to interest rate differentials, and which finally results in capital flows.

You might be wondering why this period is the weakest for illustrating the link between commodities and the US Dollar. In this cycle the GSCI index is affected by its construction by having a lower weight in oil, the key seaborne commodity at the time. This has an impact because the ‘80s was a rare period in which energy and non-energy commodities

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The trends are faster in the case of weak commodity prices because the cycle will exhibit the same links, but in an accelerated manner. Producers, worried about covering their fixed costs, are incentivised to increase supply to try to get volume to overcome the price effect, further pressuring prices downward.

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Whether you credit Paul Volcker for breaking inflation through aggressive monetary policy tightening, or a fall in oil prices due to abundant supply in the early ‘80s, by 1980 the 10-year run in commodities was over, as so was the weakness in the US Dollar.

Why the denomination of commodity pricing matters

The key to understanding the link between commodities and the US Dollar is the fact that most commodity producers have costs that are in their local currency, while all their revenues are in US Dollars, the currency in which most commodities are priced.

The timing of the bottom of the US Dollar may not be important when considering the long-term view. However, the absolute high in the US Dollar could be set at the time of the peak of the current Fed hiking episode, which will not be when the last interest rate hike is completed, but when US economic growth starts to turn downwards.

Trade finance banks also provide the ability for producers and consumers to hedge their exposures. This is far more important for producers than consumers, as consumers can ultimately pass on any price changes to customers, whereas producers have fixed costs to cover that are mostly in the currency of the country where production occurs.

At the quarterly to annual scale however, the factors to price moves become more obvious.

The key factors are:

• GDP growth differentials;

• Interest rate differentials; and

• Capital flows