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The Correlation between US Dollar & Commodities is now Broken

The Correlation between US Dollar & Commodities is now Broken

The Correlation between US Dollar & Commodities is now Broken

It’s a given in the market that there’s an inverse relationship between dollar strength and the price of commodities, but Citi Research argues that correlation is now gone.

“Commodity prices have traded in a strong inverse relationship with the US dollar over the past decade or so, but this relationship broke down in late 2016 and the breakdown looks here to stay,” analysts wrote in a note released on Monday.

Case in point—commodities generated strong returns in the fourth quarter of 2016 with the Goldman Sachs Commodity Index moving 9 percent higher despite a stronger greenback which gained about 7 percent against major currencies.

“While it’s not uncommon for commodities and USD to rally or sell off at the same time, especially when we look at their returns at a higher frequency (daily or weekly), 4Q 2016 was actually the first quarter in more than a decade to see such a sizable divergence,” the analysts added.

Key commodities traded globally such as crude oil, gold, copper and softs like wheat are typically priced in dollars, with liquidity often favor the major exchanges in New York, London and Chicago as centers of trade. But the impact of a stronger dollar on trade terms has not followed a set pattern in the past few years, Citi said.

The divergence was years in the making, with the breakdown starting in 2013 due to expectations of monetary tightening which dampened the appetite for risk assets like commodities.

“Risk sentiment started improving as the world economy recovered from the crisis and volatility came down notably across asset classes,” the Citi analysts wrote.

Even so, the strong inverse correlation between commodities and the dollar was not always a given as it “behaved more like a random walk around zero…before 2004.”

The correlation came about with the “financialization” of commodities, i.e. the growth of commodities derivatives markets around 2004, they argued. The financial crisis and subsequent quantitative easing strengthened the negative relationship, but it has faded since 2013 as volatility subsided, they added.

While it would likely not go back to a “random walk” again due to the active trade in commodity derivatives now, the correlation should remain relatively low due to contained risk aversion, they wrote. – Huileng Tan

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