By Rupert Hargreaves
A few weeks ago, technical analysts at CLSA Benthos published a research which seemed to claim that the dollar commodity correlation is breaking down.
This claim is based on technical analysis that claims the Dollar Index could move to 115 in the near term. However, commodity prices are also gaining ground, giving a reason to believe that the dollar commodity correlation is starting to break down.
Commodity prices display a predictable pattern
Over the past 100 years, commodity prices have displayed a very predictable pattern. Prices accelerate every 28 to 30 years, typically, a spike in prices is seen before a pattern of cyclical ranging price action. The January lows are likely to mark the lows for the sharp declining phase and should be seen as the initial support level and lower boundary of a prolonged basing pattern over the coming years. The next accelerated peak in this commodity series is projected out in 2038 to 2040. That's according to analysts at CLSA Benthos.
There is some research to support this conclusion. A research paper on real commodity prices by David Jacks from Simon Fraser University in Vancouver and the Massachusetts-based National Bureau of Economic Research, found that in the very long run - from about 1850 onwards - commodity prices as a whole have moved in cycles yet on a more granular basis, different trends appear.
For example, the real prices of soft commodities have been in collective and perpetual decline since 1850 - rounded out by aluminium and the related mineral of bauxite as well as zinc. "Energy products, minerals, and precious metals are clearly in the "gainer" camp, grains and soft commodities are clearly in the "loser" camp, and metals are left as contested territory."
The paper goes on:
Applying weights drawn from the value of production in 2011 suggests that real commodity prices have increased by 252.41% from 1900, 191.77% from 1950, and 46.23% from 1975. Of course, this result is largely driven by energy products. Applying weights drawn from the value of production in 2011 but which exclude energy suggests that real commodity prices have still been on the rise, having increased by 7.76% from 1900, 58.44% from 1950, and 1.97% from 1975. Applying weights drawn from the value of production in 2011 but which exclude both energy and precious metals suggests that real commodity prices have a more mixed record, declining by 3.94% from 1900, increasing by 39.91% from 1950, and declining again by 10.97% from 1975. Finally, applying equal weights (but including both energy and precious metals), real commodity prices have increased 2.01% from 1900, have increased 44.18% from 1950, and have decreased by 3.93% from 1975."
This shows that while real commodity prices do tend to trend higher over the long term, advances in technology can cap price gains as production rises to meet increased demand.
But what about the dollar commodity correlation?
Dollar commodity correlation breaking down?
The US has been in demand for much of the past decade as investors seek safety in the world's biggest reserve currency. Rhetoric from the Federal Reserve regarding tightening of monetary policy has also helped boost demand for the greenback. The dollar has now reached an interesting time in its career. The dollar's 40% rise since its quantitative easing programme has made the currency a victim of its own success. The currency has now become so strong that any attempt to tighten by the Federal Reserve threatens the stability of the financial markets - according to the Financial Times.
Is The Dollar Commodity Correlation Breaking Down?
According to CLSA, the dollar's current rally is only five years old. The past two significant dollar rallies, from 1978 to 1985 and 1995 to 2002 lasted around seven years. So, if history repeats itself, the current dollar rally has another two years to run.
Where the dollar goes next depends on Fed policy and commodity investors paying close attention to the Fed's rhetoric. Since the financial crisis there has been a very strong inverse relationship between commodities and US dollar. But this hasn't always been case. CLSA notes that the final phases of the advance in the Dollar Index (1983 to 1985 and 1999 to 2001) were accompanied by a rally in the commodity index. While research from Schroders shows that during the boom years of the 1990s, and recovery after the dotcom bubble bursting from 2003-2006 there was almost no relationship between the US dollar and commodity prices. Further analysis shows that in the period from 1990 to 2015, 61% of the time there was a negative correlation between US dollar and commodities, and 39% a positive correlation.
These trends might not be applicable this time around. In both the 80s and 90s, traditional market forces ran the market and this time around the Federal Reserve is providing a backstop - a backstop which has sponsored the recent dollar rally and funded the slump in commodity prices through its zero interest rate policy. Whatever the case, it looks as if based on both historic trends and the deteriorating fundamentals of global commodities markets, commodity prices are going to be under considerable pressure for the foreseeable future.
Disclosure: Rupert may hold positions in one or more of the companies mentioned in this article. You can find a full list of Rupert's positions on his blog.
Disclaimer: This should not be interpreted as investment advice, or a recommendation to buy or sell securities. You should make your own decisions and seek independent professional advice before doing so. Past performance is not a guide to future performance.