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Commodities and currencies

FEATURE: The weakness of the dollar has been a major contributor to strong commodity prices, says Kathleen Brooks

What's the biggest factor driving commodity prices? Chinese demand? Unrest in North Africa? Or supply shortages? These are all relevant, but you can trace the current boom in commodity prices to the words of one man: Ben Bernanke.

When the Federal Reserve chairman spoke at the Fed's Jackson Hole gathering last August, he effectively signalled that another bout of quantitative easing (known as QE2) was on the way. At the time, the Fed was worried about deflation and Mr Bernanke, a keen student of Depression-era economics, was determined to reflate the US economy.

Printing an extra $600bn had two consequences. One was to boost asset markets, since the money institutions made by selling bonds to the Fed was redeployed elsewhere, including commodity markets. The other was to weaken the dollar. On a trade-weighted basis, the US currency has lost 10 per cent since August 2010 – quite a sizeable move by foreign-exchange market standards.

The chart, below, shows this clearly. Following the Jackson Hole gathering, commodity prices (illustrated by the Thomson Reuters commodity index) took off, while the dollar headed south.

Since commodities are almost all priced in dollars, when the US currency rises it causes the dollar price of commodities to fall, and when it falls the price of commodities rise. The intervention of the Fed disrupted the greenback's normal supply and demand fundamentals, and is a big reason why we have oil at $120 per barrel.

This relationship also holds in the longer term. Bar a few instances in the past 10 years, when oil prices rise the dollar is weak and vice versa. The strength of the dollar/commodity link can also be seen in the cost of commodities priced in currencies other than the greenback. The price of oil in euros has appreciated by 25 per cent since the start of this year, this compares with a 33 per cent increase in the dollar price increase.

Big commodity currencies

Commodities and foreign exchange also interact in another way, through the currencies of large commodity producers. The free-floating currencies of commodity producers tend to move in line with commodity prices. Typically, when commodities are appreciating more money is flowing into these economies. This boosts inflation pressure, causing official interest rates to rise and the currency to rise.

Of course, domestic issues, including politics, domestic finances and disruption to local production can also affect these currencies. So while there is a relationship between commodity prices and forex rates in the producer countries, it is not a perfect one, and commodity currencies tend to be at the riskier end of the FX spectrum.

It's possible that in the future commodities will be priced in other currencies. But, until that day comes, the dollar will be crucial for commodity traders, who ignore the direction of the greenback at their peril.

Rising commodity prices helped nip US deflation in the bud; commodity prices affect all aspects of the US economy, from people buying food and petrol to companies buying raw materials for the production of cars and clothes. But will the dollar-commodity link hold when QE2 comes to an end in June? Its durability suggests that any divergence would be short-lived. The dollar index is close to record lows, so if the end of QE2 marks the end of the downtrend in the dollar, then we may eventually start to see the shine come off commodity prices.

On the other hand, dollar bears can still point to America's $14 trillion debt problem as reason enough for the greenback to continue falling. And with geopolitical tension hotting up elsewhere – North Africa, the middle east, the Korean peninsular – a commodity price pull-back is far from a done deal.

Kathleen Brooks is research director at