Dollar strength spurs price rally

In the context of previous falls – at the most dramatic, the benchmark oil price halved in 2014 and fell more than 30 per cent in 2015 – a rebound of less than 10 per cent is modest.

The benchmark CRB index of spot commodity prices has rallied by 7.3 per cent this year, having fallen 18.2 per cent over the previous two years. So what are the possible explanations for this?

Commodities are priced in US dollars and movements in the currency play a significant part in short-term price fluctuations. Analysis shows that the relationship with dollar movements varies between commodities and also depends on the time frame, so a stronger dollar is associated with weaker prices and vice versa.

The CRB index has a negative correlation with the US dollar of 76 per cent over one year and 49 per cent since the start of 2008.

Inventories and stockpiles can have an interesting story to tell but it is necessary to look at all aspects before drawing conclusions

Dollar movements are generally stronger determinants of shorter-term prices for commodities traded on global markets, such as oil and industrial metals, which in turn make up the bulk of the index.

Agricultural commodities and natural gas, which have stronger local and regional supply and demand patterns, have weaker correlations with dollar movements, as does gold. This is borne out by the performance of the commodity currencies, such as the Australian and Canadian dollars and China’s renminbi.

China is a major producer and source of demand for industrial and agricultural commodities. The currencies of producers in both the developed and emerging economies have risen along with their commodities.

Fundamental drivers in the form of supply, demand and inventories usually play out in the medium to long term, except where supply is constrained and demand buoyant, which has not been the case for traded commodities for some time.

Sudden shortages, and price spikes, are more likely in the softs or agricultural markets, for instance, when harvests fail or drought or disease wipes out livestock. Excess supply fuelled by low interest rates and a lack of supply discipline has been predominant in energy and metals.

Inventories and stockpiles can have an interesting story to tell but it is necessary to look at all aspects before drawing conclusions. For example, Chinese imports of copper have increased markedly in 2016 compared with the same period last year, while inventories in Shanghai have burgeoned.

This could be interpreted as a better demand outlook as housebuilding and infrastructure momentum improves, while rising inventory levels may indicate falling or delays to demand.

Investor flows into commodity-related investments have also picked up. In some markets, such as China, this renewed interest in real assets comes after poor performance of domestic financial markets for stocks and bonds and prospects of currency depreciation.

Elsewhere interest in real assets – including commodities – as a diversification or contrarian trade has increased.

Dollar direction has played a part in the recent rally, as has the Federal Reserve’s more dovish dots. Intimations of delays to US interest rate increases, against a backdrop where quantitative easing and negative interest rates are still being deployed by the European Central Bank and the Bank of Japan, prolong long-standing imbalances and bring an unwelcome resurrection of risk-on/risk-off trades.

While a better balance between supply and demand is part of the rationale for stronger commodity prices in 2016, more emphasis should be placed on financial factors related to the US dollar, arbitrage and investors’ interest in real assets.

Frances Hudson is global thematic strategist at Standard Life Investments