The chart showing the history of commodity prices and the U.S. dollar looks simple and I suppose that, on the surface, it is. But for investors looking to understand the recent swoon in commodity prices, and when the carnage might end, it's necessary to look deeper at the hundreds of millions of investing decisions, and trillions upon trillions of dollars, that lie behind the relationship.
The often used statement "commodities are priced in U.S. dollars so the value of the greenback moves in the opposite direction of resources" is true but a gross oversimplification. The real roots of commodity volatility were the crisis-era policies of the world's two largest national central banks – the U.S. Federal Reserve and the People's Bank of China.
During the financial crisis, Ben Bernanke slashed the interest rate benchmark from 5.25 per cent to 0.25 per cent. The strategy was to make credit so cheap that the major banks could repair their tattered balance sheets before they went bankrupt. The other part of the plan was to incentivize large investors to sell U.S. Treasuries – because lower rates reduced coupon payments – and buy equities. This in turn was supposed to increase corporate capital investment and eventually employment.
Chinese leadership, through the People's Bank of China and the country's banking system, adopted a policy that was in some ways even more drastic. In a single year, from November, 2007, to November, 2008, China's M2 (a measurement of money supply that includes savings deposits, money market mutual funds and other time deposits) jumped 30 per cent. For all the talk of the Federal Reserve "printing money," M2 expansion in the United States peaked at just over 10 per cent in 2011 – a third of China's monetary stimulus.
These central bank policies had a massive stimulative effect on commodities in both direct and indirect ways. Low U.S. interest rates weakened the U.S. dollar which raised the price of commodities. The weakening dollar and cheaper borrowing rates motivated investors (particularly hedge funds) to borrow cheaply in greenbacks and invest the proceeds in fast-growing emerging markets assets (and also directly in commodities). Cheap U.S. credit also allowed oil producers to easily finance shale drilling operations, which resulted in a doubling of U.S. oil production.
In China, the monetary explosion was used to finance one of the largest infrastructure and housing construction booms in human history. Foreign investment into the country spurred growth even further. All of this construction required a surge in imports of every commodity imaginable, as much as could be produced, and resource prices surged.
All of this is now being unwound. The excesses have been exposed and commodity prices are getting hammered.
The Federal Reserve has gone from a weak dollar, monetary loosening policy to a strong dollar, tightening policy. Cross-border investment flows that were moving from the United States to emerging markets have now reversed as investors flee BRIC countries and invest in U.S assets. Brazil, whose GDP growth benefited tremendously from exporting iron ore to China, is on the verge of a depression. Wealthy Chinese are using every means at their disposal, legal and otherwise, to get money out of the country and into developed world safe havens.
Commodity producers are now faced with an environment where there's too much of everything. Mining companies invested billions to expand production, using cheap financing in the belief that China's demand would remain insatiable. Now they are finding there's no demand for the new supply. Oil producing nations, including Canada, are suffering the same fate.
The oversupply conditions caused by over-investment – notably in oil, iron ore, steel and aluminum – must improve before investors can expect a broad recovery in commodity prices. More economic stimulus in China would help (whether or not it's a good idea for their own long term economic health) but the more likely adjustment is massive, worldwide cuts in metals and energy production.
The U.S. dollar didn't cause the boom and bust in commodities, it merely reflected the central bank policies, financial conditions and international investment flows that brought it about. Still, the path of the dollar remains an effective indicator on the future health of commodity prices and the resource industries.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.