Investors this year will have to move away from trading strategies that link commodities and other risk assets to the ups and downs of the dollar and instead focus more on the supply and demand particulars of each commodity.
For most of the second half of last year, a fresh scare in the euro debt crisis or a weak economic number could lead to a rise in the dollar, and risky assets such as equities and many commodities would sell off in lockstep.
The flip-side of this so-called “risk-on, risk-off” pattern also operated like clockwork: a weaker dollar led to a run-up in commodity prices when the outlook brightened and risk appetite rose.
This year has proved different as the dollar rises due to a nascent economic recovery in the United States and the unwinding of positions in strong emerging market currencies.
A sharp fall in the correlation between the dollar index and the volatility index, Wall Street’s so-called fear gauge based on U.S. equity markets, provides clear evidence of the changed environment.
The correlation, which averaged 0.6-0.7 in the second half and reached a peak of 0.92 in late November, has skidded below 0.1 this week.
“It means that you’re no longer going to have the knee-jerk reaction which is stronger dollar, weaker commodities,” said Nic Brown, head of commodities research at Natixis in London.
The dollar may still strengthen as a safe haven asset when markets get spooked, but there are other factors at play this year that are likely to blur moves in commodities.
“You’ll have to differentiate on any particular day between whether the dollar is going up because you’ve got risk-off elsewhere in the world and whether it’s an appreciation of the dollar due to an improvement in the U.S. economic outlook,” Brown said.
In the second half of last year, the dollar index strengthened about 8 percent and the 19-commodity Thomson Reuters-Jefferies CRB index fell 9.7 percent.
Last Friday the dollar index touched a one-year peak on strong U.S. economic data, but the CRB index still managed to rise 0.3 percent.
Fundamentals come to fore As the factors linking the dollar and commodities become more complex, the fundamentals of each commodity will increasingly make their influence felt, said Wiktor Bielski, global head of commodities research for VTB Capital in London.
Furthermore, a sell-off in some commodities to unsustainable levels, such as many base metals, is also leading to a curbing of broad, risk-based trading strategies, he said.
Many base metals prices have slid down to marginal costs, provoking reactions from producers, such as recent output cuts in aluminium.
“Late last year it was a one-way street: the speculative funds just sold commodities. It was very easy because that’s what the dollar-VIX relationship told you. It’s not telling you that any more, particularly with base metals,” Bielski said.
“You’ve got prices not far short of global marginal costs, and there’s not that much more downside risk ... It’s those fundamentals that will be more important than perhaps the dollar-VIX relationship.”
In copper, a looming market deficit, with production issues such as strikes and technical delays and expected renewed demand from China for restocking, will probably outweigh currency and risk influences, he added.
Demand for oil is expected to increase as the world economy grows, powered by emerging markets such as China. Goldman Sachs, one of the more bullish forecasters for oil, expects Brent crude to end the year at $127.50 per barrel, up 11 percent from current levels.
In agriculture, JP Morgan has said weather-related grain production disruptions are likely this year due to La Nina, dry conditions in the southern U.S. plains and drought in Ukraine.
As fundamentals reassert themselves, commodities are likely to take their own paths, diverging from equities after high correlations last year, said Colin Fenton, global head of commodities research at JP Morgan.
The correlation between the CRB and the S&P 500 index has fallen from 0.8 in late November to about 0.5.
Among commodities, gold has had the largest disconnect from factors that typically drive prices, and these should reassert themselves this year, said Jeff Currie, head of commodities research at Goldman Sachs.
The gold price has historically had a high inverse correlation to U.S. real interest rate levels, but this has declined since October.
This occurred as a sell-off in risky assets swept gold along with it as investors sought to raise dollars amid funding stresses, Currie told a strategy conference in London on Monday.
“What happens when this reverses? Because in the long-term we should be demanding commodities and put a better value on them than U.S. dollars,” he said.
The historic relationship between gold and U.S. interest rates would indicate a gold price above $1,900 per ounce, Currie added.
Spot gold, which gained 10 percent last year after touching a record of $1,920 in September, was trading at about $1,642 per ounce on Friday.