How strong is dollar-commodities link?

One of the most enduring perceptions in global markets is about the inverse relationship between the US dollar and commodity prices. In fact, such an inverse relationship and of the causation – running from the dollar to commodities - is considered almost axiomatic particularly when the dollar is on a weakening mode. Headlines such as "Tumbling dollar lifts metals on LME", "Gold hits new high as dollar crashes" and "Weaker dollar to push crude higher" are well reflective of this widely held view.
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How valid is this perception? Is it supported by price movements in the dollar and commodities over long periods of time? Going beyond the validity of this relationship at the level of financial/commodity markets (from a trading perspective), how significant is this question at the level of economic policy formulation? If it can be established that the perceived dollar-commodities link is tenuous, at best, will that provide any signal for policymakers, particularly in emerging market economies (EMEs), such as India?

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These are the questions which come to the fore in the backdrop of the fairly sharp rise in commodities prices in recent months. This has come despite the dollar broadly holding its own against other major global currencies in the past few months. Indeed, despite the magnitude of problems the US economy (and the dollar potentially) faces, the US currency, on average, has remained stable against a basket of the currencies of its important trade partners. This means that while the dollar has lost value against some currencies, it has gained against others.

This development in the dollar-commodities complex, therefore, has been at variance with the widely held perception that rising commodities should be accompanied by a crashing dollar.

To be sure, this development is in the short-term and certainly cannot provide evidence for the existence/strength of any long-term relationship or otherwise between the dollar and commodities.

What history says

What is the evidence then from the long-term data on dollar and commodity prices?

Statistical analysis (static correlation analysis) of the historical returns on dollar and commodity prices shows that the widely held view about a "strong" inverse relationship between the two is not supported - both when the dollar is on the ascendant as well as when the US currency is on a declining trend.

The statistical analysis does support the a priori expectation of a negative relationship between the two. Global commodities, after all, are priced in dollars and other things remaining equal, price movements in the two variables should be in opposite directions.

But, importantly, the historical data show that the relationship goes only that far. Other factors have remained same only to the extent of not disturbing a basic, negative relationship between the two variables.

But, going further, these other factors have had a dominant influence on the level and direction of commodities prices in the past decade and more.

For the data analysis, we considered two time periods - one during which the dollar was rising and the other during when the dollar was on a declining trend. The dollar price studied here is the US currency's effective exchange rate (index) - this gives a summarised, average measure of the US currency against its major trading partners.

The dollar strengthening period is between May 1995 and April 1999 (remember the dollar hit its all-time low of 80 yen and 1.35 German marks in April 1995. From thereon, it was a recovery for the US currency - well captured by the "strong dollar" policy of Robert Rubin).

The weak dollar period has been taken as between May 2005 and April 2009. This period saw the US currency quoted at as low as 1.65 units to the euro, two units against the pound and at 90 yen - all close to its pre-April 1995 lows).

As for commodities, we have taken the time series data on gold, spot crude oil and an index of base metals prices.

Interpretation of results

As can be noted from the table, the correlation between the dollar and commodities, though negative, is quite weak. At -0.57, the correlation between gold and dollar is the highest in the 2005-2009 period. Despite this correlation estimate being statistically significant (that is, we can be 95 per cent confident that the actual correlation between the two is not zero and could, in fact, be even the estimated -0.57), it means that just around 30 per cent of the moves in one variable are in tune with the moves with the other. The relationship is even weaker for spot crude oil and base metals.

The weak relationship inference is more valid in the 1995-1999 period.

As can be seen, the correlation estimates are not even statistically significant for crude oil and base metals in that period. This means that there is probably zero correlation between the two and the dollar.

Another inference that can be made is that the relationship between the dollar and commodities (though weak overall) is (relatively) stronger when the dollar is on a weakening trend.

This can be explained as (partly) due to the portfolio diversification and risk minimisation strategies of investors exposed to dollar assets.

The macro signal

Going farther, these statistics also provide some signals for macroeconomic policymaking. The analysis shows that the relation between the dollar and commodities is not secure. Even during the recent period of fairly severe dollar weakness, the sympathetic movement in commodities was limited. Forces larger than the dollar's value seem to have played a dominant role in driving up commodities prices strongly in the period up to July 2008. One such key force was the pressure of demand from large EMEs such as China and India.

Per contra, we can expect that even if the dollar were to register a strong performance in the ensuing period, global commodities prices need not necessarily weaken.

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This dynamic probably has to be factored into demand (and inflation) management policies in the EMEs. We cannot explain away accommodative policies - fiscal and monetary - on the ground that global commodities prices are being driven by the dollar. Historical data seem to point otherwise.