You are here:

New danger for commodity stocks

Created:
14 July 2008
Written by:
Chris Dillow

Commodity stocks face a new threat - the danger that the "Bretton Woods II" exchange rate system will break down. This system is the arrangement under which Gulf states and several Asian economies - most obviously China - peg their currencies directly or indirectly to the dollar.

Advertising

This arrangement has been fantastic for commodity producers in recent years. It means that as the dollar has fallen, Arab states and China have effectively been obliged to print more riyals, yuan and dirhams to support the greenback. This monetary expansion has helped raise demand for commodities generally. Also, by keeping their exchange rates under-valued, dollar-pegged countries have seen their export-led economies grow strongly, fuelling more demand for commodities. Just think of China's industrialisation or the United Arab Emirates' construction boom.

This explains our chart. It shows that in recent years, falls in the dollar against floating currencies have led, with a lag of around a year, to rises in commodity prices, because a weak dollar boosts monetary growth in dollar-peg nations.

However, this could all be about to change. Under-valued currencies are big contributors to rising inflation. Economists at Merrill Lynch estimate that inflation in Gulf Co-operation Council states will rise to 10.4 per cent this year, from 6.7 per cent last year. And in China, producer prices (which are subject to less official interference than consumer prices) are rising at their fastest annual rate for three years.

This is causing commentators to call upon these countries to end their under-valuations, either by revaluing their currencies, allowing them to float, or shifting to a peg against a basket of currencies (China did this in 2005, although the dollar is still probably the dominant currency in the basket).

The effect of any of these moves would be similar. Stronger exchange rates would depress domestic growth - that's why they reduce inflation. And because central banks would have less need to buy dollars to hold their currencies down, they would print less domestic currency. On both counts, demand for commodities would falter.

This danger might be one reason why mining stocks have fallen in recent weeks, despite strong rises in commodity prices. Investors just don't think the rises will last if dollar pegs are removed.

But could an end to Bretton Woods II have offsetting benefits for equities? The good news is that it would transfer growth from dollar-peg economies to the US, as the dollar strengthens against these currencies. However, this effect would be small. Exports account for only one-eighth of US GDP, and are not very sensitive to exchange rates.

The bad news is that bond yields could rise, as a massive source of demand for US treasuries - buying by dollar-peg central banks - slows down, causing bond prices to fall. This could lead to rising yields around the world, not just the US. Higher risk-free yields mean that equities would have to offer corresponding higher returns, which suggests that share prices would have to fall.

MORE FROM CHRIS DILLOW...

Read more of Chris's comment pieces on his Columnist page, or his macroeconomic analysis on the markets page.

Chris blogs at http://stumblingandmumbling.typepad.com

  • Back to top

GLOBAL BANKING CRISIS

Get the latest news here!

Promotional Feature

The world's oldest pets

We all want our pets to live long and happy lives. One of the easiest ways to help your four-legged friend get over life's many hurdles is to get them covered with pet insurance.

by Sainsbury's

Promotional Feature

Turkey Resort Round-up – Beyond Istanbul

Holidays to Turkey tend to focus on the country's magnificent coastline. Dotted with coves and lined with sandy beaches, Turkey is a sun-worshipper's paradise.

by TUI