Inflation is now the No. 1 bugbear for the markets. It’s squeezing margins, raising interest rates and hurting demand for consumer durables. Hong Kong-based research outfit Gavekal says investors should watch out for signs that food prices are rolling over, as has already happened with wheat prices. If inflationary pressures turn down, Gavekal says a large weight will be removed from Asian equity markets, leading to a reversal of recent weakness.
After some initial confusion, the dollar has strengthened on the expectation that further Fed rate cuts are doubtful. Fed fund futures are signalling the same thing. With the dollar strengthening to a seven-week high against a basket of currencies, commodity prices have been pushed back.
Dollar vs commodity prices
It’s important to check the correlation between the dollar and commodity prices. Taking data over the last 15 years, the Goldman Sachs Commodity Index (now the S&P Goldman Sachs commodity index, after it was sold to Standard & Poor’s) was at 180 in January 1993 and, after some ups and downs, it remained at around 180 in January 2002. Over this nine-year period, the dollar index moved up from 86.85 in January 1993 to 115.56 in January 2002. In other words, the dollar appreciated by one-third of its value in these nine years, but the commodity index ended the period at the same level as it was in 1993.
Now, consider the years after 2002, when the dollar index fell from 115.36 to 79.57 in April 2008, a decline of 31%. Over the same period, the Goldman Sachs commodity index moved up from around 180 to 750, a rise of 316%. The data tells us several things. For starters, the correlation is less than perfect. Otherwise, commodity prices would have fallen between 1993 and 2002 when the value of the dollar went up. But that didn’t happen, because world growth was strong and demand from the Asian economies was rising. Allowances also need to be made for the Asian crisis, which would have reduced Asian demand.
In fact, the commodity index had risen from 180 in January 1993 to around 230 by December1996, but then the Asian crisis took its toll and the index plummeted to 130 by the end of 1998. Thereafter it started rising again, reaching a peak of around 260 by the end of 2000 before starting to move down. The period 2000-02 saw the dotcom bust and a slowdown in the US, which too affected commodity demand. In other words, the last two big global growth slowdowns have been accompanied by lower commodity prices.
Clearly, the direction of the dollar is inversely correlated to the direction of commodity prices. For example, the dollar index fell between 1993 and 1996, when commodities were rising. Thereafter, it strengthened briefly in 1997 and 1998 as a result of the fallout of the Asian crisis. And it moved up between 1999 and 2002 while commodity prices softened from 2001. While the dollar moved up from 1999, commodity prices started falling only after a lag.
US slowdown, credit crisis
The other interesting fact is that during the 2000-02 slowdown in the US, the dollar actually strengthened. That’s very different from what’s happening now, but perhaps it could be explained by the fact that other central banks too were reducing their policy rates at the time, so the money didn’t flow out of the US.
In the last few months, however, commodity prices have shot through the roof, with the Goldman Sachs index rising from around 480 in August to 750, a rise of 56%. This is also the period in which the US Federal Reserve has been cutting rates in response to the credit crisis and, as a result, the US dollar has been falling. Since September, the dollar index has fallen around 6%, far more sharply than in the preceding months. Simply put, while other factors such as Asian demand and speculation are also responsible for the rise in commodity prices, the falling dollar has to shoulder its share of the blame. That is why, if the dollar has bottomed out for now, it should ease inflationary pressures, helping corporate earnings.
But whether the dollar bounce is sustainable depends on a host of factors, such as the extent of the US slowdown and whether the housing crash leads to lower US consumption — economists have been making the point that the slowdown has so far not spread outside the US to a significant extent because the housing sector has few international linkages. It’s when US consumption is hit that the rest of the world will wake up. Also, unlike in the early 2000s, Asia is not in recovery mode now, so commodity demand is higher. Also unlike in 2000-02, neither Europe nor Japan has been cutting interest rates. All this may keep the dollar low and commodity prices high.
And lastly, a stronger dollar may not be unalloyed good news. During the bull run of 2003-07, we were often told that one of the reasons for the flow of money to emerging markets was the weak dollar. With the dollar weakening on account of large US current account balances, so went the story, it didn’t make sense to invest in dollar-denominated assets. That argument has fallen by the wayside in the last few months but the point is that, in the past, periods of dollar strength have not been good for emerging markets.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org