The global financial marketplace is a complex, interconnected organism where every company, commodity, and financial asset is just a piece of a much larger picture. What happens with one asset can influence another, and so on. There’s a relationship that exists between asset classes that, while not perfect, tends to follow a pattern over time.
The relationship usually follows a certain order – currencies up, commodities down, bonds up, and stocks up or down. It works in reverse as well with commodities going higher if currencies fall. Keep in mind that commodity values play a bigger role in this relationship than it might appear – commodity prices drive stock and bond performance. Let’s take a look at how this works.
As commodity prices rise, the cost of goods goes higher triggering inflation and a subsequent rise in interest rates. Bond prices and bond yields have an inverse relationship so higher yields means lower bond values. And stocks will usually follow suit once bond prices begin to decline.
The Dollar's Role in the Asset Cycle
The dollar stands out among global currencies because it’s the de facto currency of choice used in trading. Commodities are generally priced in dollars and there is a significant inverse relationship between the value of the US dollar and commodity values. Because commodities are traded globally, a drop in the value of the dollar means a rise in a foreign country’s currency, which in turn means more buying power for commodities. This increases demand and, as such, values rise.
When the US dollar is strong, commodities become more expensive to purchase and demand drops. Commodity suppliers must reduce prices in order to meet the new market demand. Businesses can profit from lower commodity prices such as airlines being able to take advantage of lower oil costs. Stocks rise as margins go up and bonds along with them.
The US dollar is also used as a safe haven asset by the global financial marketplace. When the economy is experiencing volatility or there’s poor growth in foreign markets, investors flock to the relative safety of the dollar creating higher demand for the currency and further pushing commodity prices down.
However, long term low commodity values can result in a decline in manufacturing and production, which ultimately hurts economic growth. This reversal can tip the scales the other way and lead to a lower dollar value and a rise in commodity prices starting the cycle anew.
The activities of the Federal Reserve strongly influence the value of the dollar as well. Higher interest rates were actually, historically, bullish for currencies allowing investors to take advantage of higher carry interest. It creates downward pressure on commodities but it also makes the cost of obtaining loans more expensive, which negatively impacts bond prices and stock values. When these start to decline, the dollar will slip and commodity value will rise.