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Commodity Prices Benefit From Weakening Link To U.S. Dollar

By Andy HechtCommoditiesApr 01, 2022 18:38
Commodity Prices Benefit From Weakening Link To U.S. Dollar
By Andy Hecht   |  Apr 01, 2022 18:38
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  • Historical relationship between the US dollar and commodities
  • China makes a move, Saudi Arabia and Nigeria follow
  • Russia will not price commodities in dollars
  • Reserve currency status at risk
  • Bearish for dollar, bullish for raw material prices

The US dollar has been the world’s reserve currency for decades. Reserve-currency status comes from political and economic security. Countries use reserve currencies to settle cross-border transactions and hold them as reserves or savings. A reserve currency must be fully convertible to other foreign exchange instruments in the free market. Since the turn of this century, the US dollar and the euro have been the two leading reserve currencies.

The US is the world’s leading economy, but Chinese growth means it is nipping on its heels. China has long wanted the yuan to challenge the US dollar for reserve-currency status. In 2022, geopolitical events have caused tensions to rise between the US and the newly formed Chinese-Russian “no-limits” support agreement. Russia’s invasion of Ukraine and sanctions have accelerated a global ideological and economic divide. The dollar and the euro’s position in the global financial system could be on a weaker footing, which has significant ramifications for the price of commodities over the coming months and years.

Historical Relationship Between the US Dollar And Commodities

The dollar’s position as the world’s reserve currency makes it the benchmark pricing mechanism for most raw materials. The currency markets and commodity prices are linked as a rising dollar makes commodities more expensive in other currencies. In a typical environment, when local prices rise, consumers tend to cut back on purchases or search for substitutes putting downward pressure on prices. Conversely, when prices fall in other currency terms, consumers often increase their buying. Therefore, a strong and rising US dollar tends to weigh on commodity prices, while a weaker dollar often pushes raw material prices higher.

If the dollar loses its position as the world’s reserve currency, it will weaken the relationship with commodity prices as countries worldwide look to other currencies to price their raw material requirements.

China Makes a Move, Saudi Arabia, Nigeria Follow

China is in the final stages of testing its digital yuan, which would make the Chinese currency the first major foreign exchange instrument to embrace fintech and blockchain technology. On Feb. 4, China and Russia agreed to a $117-billion trade agreement. Sanctions on Russia will prevent US dollar pricing on the flow of commodities between the two countries. Moreover, Russia recently told Europe that it would need to purchase energy in rubles, exchanging euros for the Russian currency. Ruble purchases for European energy would stabilize Russia’s currency, despite the sanctions.

Aside from Russia, Saudi Arabia, the world’s leading petroleum producer, is considering selling China the energy commodity for payment in yuan instead of US dollars. The Saudis have been neutral in the tensions between the US and Russia. Moreover, the pending nuclear non-proliferation agreement with Iran, and US criticisms of Crown Prince Mohammed bin Salman have caused US-Saudi relations to deteriorate. Russia’s cooperation with OPEC has strengthened the ties between Moscow and Riyadh.

Nigeria, another oil producer and the country with Africa’s leading gross domestic product, has been encouraging local businesses importing goods from China to use the yuan instead of the US dollar to support its naira currency and boost reserves.

Russia Will Not Price Commodities In U.S. Dollars

While the US and Russia are not engaged in a military conflict, the sanctions and retaliatory measures amount to an economic war between the nuclear powers. The US has called Russian President Vladimir Putin a war criminal, and Russia has blamed the US for moving NATO troops closer and closer to its sovereign territory over the past years.

As Russia prepared for the invasion of Ukraine, the central bank reduced its dollar reserves in favor of gold and euros. The Russian government’s insistence that Europe pays for natural gas and oil in rubles is a rejection of the US dollar. Russia will likely continue to move away from dollar pricing in many exports, including wheat, metals and energy, over the coming months and years. Even if the war in Ukraine ends with a compromise, Russian-US relations will remain more than challenging in the future.

Reserve Currency Status At Risk

The war in Ukraine and the China-Russia “no-limits” support agreement has ended the trend toward globalism in the worldwide economy. An ideological bifurcation puts China-Russia and their allies and the US-Europe and their allies on opposite sides. While neither side wants a third world war, tensions will continue to mount, causing dramatic changes in commerce and the global economy.

The US dollar has been the world’s reserve currency since the end of WW II. The shift in the geopolitical landscape threatens the dollar’s position, which significantly impacts commodity prices and the raw material asset class’s historical relationship with the US currency.

Bearish For Dollar, Bullish For Raw Material Prices

Many market participants measure the dollar’s strength or weakness by monitoring the US Dollar Index.

U.S. Dollar Index Weekly Chart.
U.S. Dollar Index Weekly Chart.

Source: Barchart

As the chart shows, the dollar index has strengthened from 89.165 in early 2021 to the most recent high of 99.425 in March 2022, an 11.5% rise. Meanwhile, the dollar index measures the US currency’s value against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. The index has a 57.6% exposure to the euro, which dominates the price action in the dollar index. The double-digit percentage gain in the dollar index over the past five quarters would typically be bearish for commodity prices. However, the index is a mirage if the dollar loses its position as the world’s reserve currency.

Measuring the dollar’s strength against commodity prices could be a better guide to dollar strength or weakness. Since the January 2021 highs, the following commodities have experienced substantial percentage gains:

  • Crude oil: At $107.30, NYMEX crude oil futures are 99% higher.
  • Gold: At $1,934, COMEX gold futures are 1.3% lower.
  • Copper: At $4.74, COMEX copper futures are 27.4% higher.
  • Wheat: At $10.30, CBOT wheat futures are 48.6% higher.
  • Natural Gas: At $5.53, NYMEX natural gas futures are 90.8% higher.
  • Corn: At $7.4150, CBOT corn futures are 33.9% higher.
  • Soybeans: At $16.73, CBOT soybean futures are 16.3% higher.

Over the past 15 months, the stronger dollar has only caused gold to decline slightly from the January 2021 high. The bottom line is that most other commodity prices are significantly higher over the period despite the US dollar’s strength, meaning they have rallied even more in the currencies that comprise the dollar index.

The decline of the dollar as the world’s reserve currency could be a core component of the Chinese-Russian strategy to challenge the US’s position as the world’s leading economy. The ideological rift is bearish for the dollar and will continue to erode its position as more countries abandon dollar pricing for commodities. The historical relationship between the dollar and commodity prices is weakening, which has been bullish for the raw materials asset class.

Commodity Prices Benefit From Weakening Link To U.S. Dollar

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Commodity Prices Benefit From Weakening Link To U.S. Dollar

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