Commodities and US Dollar

It is well-known fact that there is a causation effect between commodities and US dollar. After all commodities, like gold, oil and grains are all priced in dollars. Moreover, the mainstream media has attributed much of the recent climb in commodities prices to recent weakness in the dollar. So all things being equal, the commodity should move in the directly proportional opposite direction of the dollar.

The only problem with this argument is that all things never remain equal. The stable cause and effect market relationships will only work up to a certain limit. That depends on the time period you look at.

From December 1989 to September 2000, the relationship of oil and the dollar was positive. When one when up, the other went up. On the other hand, since February 2006, the relationship has been negative. When oil was crashing, the dollar was rising sharply. And over the past four months, oil has recovered and the dollar has fallen.

The move in oil and other commodities, along with stocks, bonds and currencies, are tracking one key thing – perception of the health of the global economy. When the economic and financial crisis commented, the CRB Index fell 58% and the Dollar Index rallied 25% and that was because of fear and uncertainty. Capital fled all risky assets, commodities included, and found safety in US Treasuries and US dollar.

Now, oil is moving higher and the dollar has been moving lower. This time, it is a retracement of the flight to safety trade. Money flowing back into commodities and other higher risk assets and out of the safety of US dollars and longer term US Treasuries, coinciding with Fed Chairman Bernanke’s first mention of ‘green shoots’. The US stock markets ip 44%, the CRB Index climbed 33%, crude oil up 120% and copper rose 97% respectively.

But the Dollar Index has lost only 12%, not exactly tick-for-tick linkage that many would suggest. Also, gold, the notable inflation hedge, has risen only 3% and it seemingly to suggest that the entire move has little to do with inflation arguments.

For that reason, I think this run-up in commodities and stocks provides the perfect opportunity to reduce risk – not add it. Today’s winners could soon be tomorrow’s losers.