You can buy commodities with money (yes, obviously). Commodity prices (or any asset for that matter) go up or down in value depending on supply and demand. Thus the currency that you intend to use also goes up or down in value. That happens because of the supply and demand of that currency, relative to others. There are other factors affecting currency values like interest rates, political factors, and economic factors. As the currency’s value changes, its buying power changes and that changes how much you can buy with it. Thus currencies and commodities are independent in some ways but also closely connected in other ways.
This relationship between commodities and the dollar is interesting and important to factor in when making investment decisions. For the sake of simplicity, let’s take oil as an example.
The Simple Answer
The usual answer you will read on this topic is that commodities and currency have an inverse relationship. Take the last 10 years for instance. The chart below indicates the relationship between the Real Dollar Index and oil prices. Why do we need to use a dollar index in our comparison instead of the dollar? If you want to know if the value of the dollar is going up or down, you must compare it with other currencies. If the dollar goes up against most of them, then it has gained value, and if it has fallen against most, then it has lost value. So the dollar index takes a weighted average of these gains and losses against currencies from the euro zone, Canada, Japan, Mexico, China, the UK, Australia, India and more.
In the graph below the inverse relationship will seem obvious. Most commodities are priced in dollars. If the value of the dollar increases then more oil can be bought (meaning the value of oil is lower) and vice versa. The other reason that adds to the inverse relationship is that countries buying commodities from the U.S. pay in U.S.dollars. If the value of the dollar drops, the value of their local currency increases. So these countries can and tend to buy more of those commodities. That means increased demand and that in turn means an increase in commodity prices.
No matter how you peel the onion, all methods lead to the same result. There is little value in digging into more details, unless you are an economist or a theorist. The basic point for investors to understand is that the theory of inverse relationships holds good.
A More Nuanced Answer
Read the graph carefully and you will notice that the extent of the inverse relationship is not equal. If the dollar falls by 10%, it doesn’t result in a 10% increase in oil prices. For example, in the graph below, oil prices have fallen 28% in the last six months, whereas the U.S. Dollar Index has risen 2.68%. Yes, there is an inverse relationship on a larger timeline but the extent to which the two figures go in opposite directions varies. In fact, on a smaller timeline they may go in the same direction too, which is shown in the red box below.
This happens because both the U.S. dollar and oil have some factors affecting them independently. For example, since 2008, due to the shale revolution, U.S. imports of oil and oil-related products have fallen sharply. From 12 million barrels per day in 2008, the imports have fallen to around 7 million barrels per day. As per Goldman Sachs’ Jeffrey Currie, this has reduced the correlation between the U.S. dollar and crude oil prices. The war in Syria has had its own effect on the oil prices and so has the supply glut as well. A lot of this has had a unique effect on oil prices.
The same situation applies to the dollar too. It has had its own relationship with the various currencies of the world. Each country has its own reasons to manage the supply and demand of their currency. All those relationships affect the dollar in a unique way. The graph below shows the percent value by which the dollar has risen against some major currencies around the world in the past year.
The Bottom Line
A commonly accepted understanding is that the value of the dollar and commodity prices usually go in opposite directions. If you take a closer look, you will see that extent to which they might go in opposite directions varies. Also, on smaller timelines, they might even go in the same direction. This understanding doesn’t give investors any specific investment decision-making capability but it does help in making more informed decisions. In the coming months, interest rates are likely to go up and the conflict in Syria might be a long one. Both of these factors mean that the dollar is likely to gain more in value. To learn more about rising interest rates read Risk Factors for Rising Interest Rates.
Follow me on @tanmoyroy for more frequent updates.