It’s time for your reminder that most commodities are priced in US dollars

The commodity rally since June has been impressive, and it could be tied to weakness in the US dollar.

Those sharp increases — ranging between 15-40% — have had Morgan Stanley strategists slightly puzzled.

On one hand, bulk commodities such as iron ore and coal have benefited from steady increases in demand.

“Similarly, restocking in zinc and nickel markets have helped lift prices of those trades,” the analysts said.

However, they added that fundamentals alone can’t explain the rise in the prices of copper, aluminium and lead.

That suggests some of the price action is being driven by an external factor: the recent weakness in the US dollar.

The analysts noted that this is the second commodity rally within the last year that’s been directly connected to the US dollar.

But the first one was the other way round — commodities staged a 4-week rally in the wake of the US election last November, when the US dollar was also rising.

So why the difference? According to Price and Bates, it’s because the outlook for inflation has now largely reversed.

“Post-election, markets positioned for new inflation risk, on the promise of a US infra-build story,” they said.

But infrastructure reform is yet to get off the ground amid political gridlock in Washington, and US inflation remains stuck below the Federal Reserve’s target rate of 2-3%.

Currency markets have reacted by driving the US dollar lower throughout most of 2017. So it follows that commodities priced in US dollars have benefited from a fall in the greenback while overall commodity-demand remains unchanged.

“The fact that the US dollar index dropped below its Nov-16 level in Jun-17, is probably one basis for Commodity World’s price rally since then,” the analysts said.

It adds an extra layer of interest in terms of the outlook for the Australian dollar.

While the AUD has pushed higher against the greenback as part of broader US dollar weakness, it’s also gained from the renewed strength across commodities and base metals.

As this chart via AxiTrader’s Greg McKenna shows, moves in the AUD this month have been closely correlated with increases on the Shanghai metals exchange:

Looking again at the fundamentals, Price and Bates warned of seasonal factors ahead.

The start of the northern hemisphere winter usually brings a pullback in production and trade, which will impact commodity prices from the demand side. They added that industries typically start preparing for reduced trade volumes in September and October.

On the currency side, Price and Bates assessed the likelihood of market drivers which would cause the US dollar to stabilise and/or climb.

They cited the possibility that US lawmakers unexpectedly bring forward the time frame for the roll-out of new infrastructure spending.

The pair also considered a somewhat counter-intuitive scenario, where the US economy continues to deteriorate and negatively impacts the rest of the global economy.

According to Price and Bates, that may allow exchange rates to stabilise and provide grounds for a US dollar recovery.

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