The US Dollar as a Commodity Currency

Key Points

The traditional view holds that the negative correlation between the effective exchange rate of the US dollar and commodity prices is mainly due to the US dollar being the global reserve currency, with the Federal Reserve's monetary policy significantly impacting the global financial cycle and liquidity environment. After the impact of the COVID-19 pandemic, a positive correlation between the effective exchange rate of the US dollar and commodity prices has emerged, suggesting that the US dollar has also become a commodity currency.

Further observation reveals that the key change lies in the US export structure, with the proportion of commodities such as crude oil in US exports on the rise. Through the trade conditions set by the US, the relationship between commodity prices and the real effective exchange rate of the US dollar has shifted from negative to positive.

The recent strengthening of the real effective exchange rate of the US dollar has brought depreciation pressure to other economies and restrained the expansion of global liquidity, exacerbating the contraction effects of the global financial cycle. Looking ahead, with expectations of a US economic recession and Fed rate cuts on the rise, the possibility of a weaker US dollar is greater. Under these conditions, it remains to be seen whether commodity prices will decline with decreasing demand, confirming the US dollar's commodity currency attributes, or stabilize and rise benefiting from looser global liquidity, thereby returning to the traditional relationship between commodity prices and the US dollar.

Main Content

For a considerable period, there has been a clear negative correlation between the effective exchange rate of the US dollar and commodity prices: a stronger US dollar leads to weaker commodity prices, while a weaker US dollar leads to stronger commodity prices. However, keen observers and cross-market traders can easily notice that after the COVID-19 pandemic, a positive correlation between the effective exchange rate of the US dollar and commodity prices has emerged. What are the reasons behind this, and how will the relationship between the two evolve in the future? This article attempts to analyze this.

The traditional view holds that the negative correlation between the effective exchange rate of the US dollar and commodity prices is mainly due to the US dollar being the global reserve currency, with the Federal Reserve's monetary policy significantly impacting the global financial cycle and liquidity environment. The Fed's monetary policy tightening and the strengthening of the US dollar have a contraction effect, leading to global financial conditions tightening, reduced international trade and cross-border capital flows, especially debt capital flows, slowing global growth, weakening demand, and consequently driving down commodity prices, and vice versa. Previous research by the Bank for International Settlements suggests that the effective exchange rate of the US dollar and commodity prices (and their inverse relationship) are the main proxy variables for the expansion and contraction of the global financial cycle at the price level.

However, a new study titled "Commodity Prices and the US Dollar" by the Bank for International Settlements in March 2023 found that although calculations using data from 1986 to 2022 show a significant negative correlation between commodity prices and the real effective exchange rate of the US dollar, the simulation error of the model from late 2020 to 2022 was as high as nearly 30%. In summary, during this period, the rise in commodity prices should have corresponded to a US dollar depreciation of about 7%, but in reality, the US dollar appreciated by nearly 20%. In other words, after the impact of the COVID-19 pandemic, the US dollar and commodity prices have changed from a negative correlation to a positive correlation. This raises an interesting topic: if a currency strengthens when commodity prices rise and weakens when they fall, we call it a commodity currency. Typical examples include the Australian Dollar, Brazilian Real, Mexican Peso, and Norwegian Krone, whose exchange rates move in tandem with the prices of major commodities such as iron ore, crude oil, and agricultural products. After the impact of the COVID-19 pandemic, the US dollar seems to have also become a commodity currency.

This paper further reveals the logical relationship: there is a stable positive correlation between the real effective exchange rate of the US dollar and the US trade conditions (US export prices/import prices). In other words, when US trade conditions improve and export prices rise relative to import prices, the US dollar appreciates; when US trade conditions deteriorate and export prices fall relative to import prices, the US dollar depreciates. Upon further observation of US trade conditions, the key change in recent years has been the US export structure. Since the shale oil revolution in the 2010s, the proportion of crude oil and natural gas in US exports has been increasing, leading to a 10-percentage-point increase in the proportion of commodities in US exports from 2000 to 2022, exceeding 20%. Especially around 2019, as the US transitioned from a net importer to a net exporter of traditional oil products, the relationship between the prices of commodities such as crude oil and US trade conditions changed from negative to positive, thereby turning the relationship between commodity prices and the real effective exchange rate of the US dollar into a positive correlation, consistent with the characteristics of a commodity currency.

Will the relationship between the real effective exchange rate of the US dollar and commodity prices continue to move in the same direction in the future? Let's not rush to draw this conclusion. On one hand, the relationship between the US dollar's effective exchange rate and trade conditions is only a correlation, not a causal relationship. Behind this lies the economic fundamentals and monetary policy stances of the US compared to major economies such as the Eurozone and Japan. In the current inflation and monetary tightening processes initiated by developed countries due to the COVID-19 pandemic, the US has indeed been leading with higher inflation and earlier and faster rate hikes, strengthening the US dollar during rising commodity prices and inflation. However, as monetary policies among major countries begin to diverge, the probability of the Fed cutting rates is higher, while the Bank of Japan is more likely to continue raising rates, weakening the support for a strong US dollar. On the other hand, the impacts of the COVID-19 pandemic and the Russia-Ukraine conflict on commodity supplies, the damage to the economic fundamentals of the Eurozone, the decrease in the share of US export income from foreign services trade, and the surge in US exports of oil products to Europe are all factors simultaneously boosting the US dollar's effective exchange rate and commodity prices However, this impact is a one-time shock, and its influence is not sustainable.

The current strengthening of the US dollar's real effective exchange rate has brought depreciation pressure to other economies and suppressed the expansion of global liquidity, exacerbating the contraction effect of the global financial cycle. Looking ahead, with the growing expectations of a US economic recession and Fed rate cuts, the possibility of a weaker US dollar is greater. Under these conditions, it remains to be seen whether commodity prices will decline with decreasing demand, confirming the nature of the US dollar as a commodity currency, or if they will benefit from the trend of looser global liquidity and stabilize and rise, thus returning to the traditional relationship between commodity prices and the US dollar.

Author: Xie Yaxuan S1090511030010, Source: Xuan Yan Global Macro, Original Title: "Becoming the Commodity Currency: US Dollar"