Expert forex traders have long understood that buying and selling currencies entails stepping outside the Forex (F.X.) market. Supply and demand, interest rates, politics, speculative activity, and economic expansion are a few elements influencing currencies. More specifically, some currencies usually correlate strongly with commodity prices because a country's exports and economic growth are strongly tied to its domestic sector.
The dollar's value and the cost of commodities typically have an inverse relation. When the dollar value rises relative to other major currencies, the price of commodities tends to fall. When the dollar's value falls relative to other major currencies, the price of commodities tends to rise. This is a general norm, and while there isn't always a strong inverse relationship over time, there is frequently one.
When compared to a chart of the dollar index, the Commodity Research Bureau (CRB) Index tracks the prices of a variety of different commodities. This Index shows how the U.S. dollar performs compared to other foreign exchange instruments.
Why does the Dollar movement lead to a struggle for emerging market economies?
The dollar is the world's "invoicing" currency and has the highest purchasing power. The dollar's value has a significant impact on commodity prices. as the benchmark pricing unit for most commodities. Most other countries keep dollars as reserve assets since the dollar is often the most stable foreign currency instrument.
A strong dollar frequently slows down the expansion of global trade. It is one of the major causes of high commodity prices. This means that other currencies decline when the dollar value increases, rendering the world poorer and less able to conduct trade.
It makes countries with debt in dollars less creditworthy because it is more difficult to buy U.S. currency to pay off their loans. It is probably less advantageous for China as well. Due to their interconnected supply chains and high commodity demand, a strong dollar may negatively affect developing markets.
Most emerging markets often buy their commodities in U.S. dollars. A strong currency is thus more likely to increase inflationary pressures in those economies, representing the relationship between inflation and commodity prices.
Commodities are Global Assets
The fact that commodities are international assets and are engaged in global trade is another factor contributing to the dollar's sway. Foreign customers use dollars to buy American commodities, including corn, wheat, soybeans, and oil. There is a disproportionate reliance on commodities for countries that export oil, like Brazil, Mexico, and Russia, as well as those that export metals and agricultural products, like Chile and South Africa.
These countries have more purchasing power when the dollar value declines because they need less of their currencies to buy each dollar. According to conventional wisdom in economics, demand often rises as prices fall.
The dollar is the primary benchmark.
Trade in commodities doesn't happen in a vacuum. Production of commodities is frequently a regional activity. The U.S.'s fertile soils are where most of the world's corn and soybean are grown. The Middle East has about half of the world's oil reserves. Chile's mineral-rich land produces the largest copper output of any other country. Africa's Ivory Coast and Ghana are the regions that produce most of the world's cocoa beans.
The temperature and geology in particular regions affect the production of commodities. Yet the people and businesses who need these crucial raw materials are spread out globally.
Because of the U.S.'s robust and stable economy, most of these raw materials use the dollar as a pricing mechanism for international trade. In other currencies except for the dollar, commodities increase in price when the dollar becomes stronger. This effect typically negatively impacts demand, and as you might anticipate, when the dollar falls, the commodity prices in other currencies decrease increasing demand.
Impact of the dollar on Commodities
The dollar's fluctuating value relative to other currencies can significantly impact. A country's ability to benefit or lose from the currency movement depends on whether it exports or imports commodities.
Despite the unique qualities of each commodity, all commodity prices have been directly impacted by the dollar's value historically. The U.S. dollar index was trading at 78.93 on the active month futures contract as the dollar started to become stronger in May 2014. The dollar increased by almost 23% in less than two years when that dollar index traded at around 97 in March 2016.
Over that time, the prices of many commodities decreased, providing an excellent illustration of the inverse link between the dollar and commodity prices. Historical correlations can be used as a guide.
Along with many other economic data, the Federal Reserve Bank (FRB) of St. Louis tracks a database with historical commodity prices. It's a fantastic starting point for any queries anyone can have concerning the current economic trend, commodities prices in 2022, or the past.
Still, there are also instances when significant divergences occur, so it's feasible that commodities prices and the dollar will occasionally move in the same direction.
Is the Wind Changing?
According to a 2017 study by Citi Research, the relationship between the dollar and commodity prices became less significant after the dollar index peaked at roughly 97 in 2016.
In particular, commodities performed well in the second half of 2016 despite the strengthening dollar relative to other major currencies. It was the most significant change in the connection in ten years. Citi stated that it believed this situation would persist for some time. The U.S. dollar index was around 97 in June 2019 after swinging lower during 2018, when numerous commodities had experienced year-over-year declines.
Bottom Line
If you want to trade commodity currency such as the dollar, the best strategy to include commodity prices in your trading is to monitor changes in the currency market and commodity prices. There is typically an opportunity to overlay a more significant movement in the commodity market onto that of the currency market because of the slightly delayed influence of these movements on the currency market.
