The Impact of the Dollar on Commodity Prices

Why Movement?

The main reason for the impact of the dollar’s value on commodity prices is that the dollar is the primary pricing mechanism for most commodities. The American currency is the world’s reserve currency. The dollar tends to be a more stable foreign exchange tool, which is why most other countries hold dollars as reserve assets.

Commodities Are Global Assets

Another reason for the dollar’s impact is that commodities are global assets. They are traded worldwide. Foreign buyers purchase American commodities such as corn, soybeans, wheat, and oil with dollars. When the dollar’s value declines, they have greater purchasing power because it takes smaller amounts of their currencies to buy each dollar. Classical economics teaches that demand typically increases when prices fall.

The Dollar Is the Benchmark Due to Its Stability

Commodities do not trade in a vacuum. The production of commodities is often a local affair. The majority of the world’s corn and soybean production comes from the fertile lands in the United States. Chile produces the largest copper output in the world from its mineral-rich soils, and half of the world’s oil reserves are located in the Middle East. The largest producers of cocoa beans are in Africa, in Côte d’Ivoire and Ghana.

As you can see, the production of commodities depends on the climate and geology in specific locations, but the people and companies that want to acquire these essential raw materials are spread throughout the world.

The majority of these materials use the dollar as the pricing mechanism for global trade due to the strong and stable U.S. economy. When the dollar strengthens, commodities become more expensive in non-dollar currencies. This negatively affects demand, and as expected, when the dollar weakens, commodity prices in other currencies fall, increasing demand.

The Impact on Commodities

Each commodity has unique characteristics, but historically, the dollar’s value has had a direct impact on prices across all commodities. When the dollar began to strengthen in May 2014, the U.S. Dollar Index traded at 78.93 on the active month futures contract. By early March 2016, this index was trading around 97; the dollar rose by about 23% in less than two years.

During that period, the prices of many commodities fell – a perfect example of the inverse relationship between the dollar’s value and commodity prices. Historical relationships can serve as indicators because history tends to repeat itself, but there are times when significant deviations occur, so it’s possible for commodity prices and the dollar to move in the same direction at times.

Is There Change on the Horizon?

Citi Research reported in 2017 that the correlation between the dollar and commodity prices had become less significant after the Dollar Index was trading around 97 just a year prior. Specifically, commodities were strong in the second half of 2016, even as the U.S. dollar rose against other currencies. It was the largest divergence in correlation over the past decade. Citi indicated that they believed this situation might persist for some time. By June 2019, the U.S. Dollar Index was around 97 again, after fluctuating downward throughout 2018, while many commodities had declined over the year.

Monitoring the Dollar

One of the best ways to hedge against change, and to monitor the dollar’s value and its relationship to commodities, is to watch the prices of the U.S. Dollar Index (Ticker: DXY).

This index is traded on the ICE Futures Exchange. This futures contract is an indicator that evaluates the dollar against a basket of other major currencies around the world, including the euro, yen, and British pound. The price of the index trades like any other futures contract and moves up and down during trading hours.

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Commodity prices inevitably rise with every decline in the dollar index, but there is often a strong inverse relationship in the long term. Individual commodities have fundamental supply and demand characteristics, so they can move in one direction or another sometimes, regardless of the direction of the U.S. dollar. Risk aversion plays a role, especially in recent events. Monitor the situation closely and do not take past trends too seriously.

Frequently Asked Questions (FAQs)

How can you trade DXY?

There are many ways to trade the dollar index. The easiest way to trade DXY for stock traders is through ETF funds. For example, UUP is an ETF fund that provides upside exposure to the dollar index. When DXY rises, UUP rises, and vice versa. UDN is the exact opposite – an ETF fund that provides downside exposure. Futures traders can trade DXY through USDX. Forex traders typically rely on trading currency pairs rather than a single currency index, so they take a bullish or bearish position on the dollar against another currency.

Where can you find historical commodity prices?

The Federal Reserve Bank of St. Louis maintains a database that contains historical commodity prices along with many other economic data. It is a great place to start looking for any questions you have about economic trends. Commodity indices are also closely tracked by traders, so charting software designed for traders will give you access to historical commodity prices along with technical indicators and other charting tools.

Source: https://www.thebalancemoney.com/how-the-dollar-impacts-commodity-prices-809294

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