Why the U.S. Dollar Matters for Commodity Markets
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If you're a professional commodity trader, you are very aware that macroeconomic inputs and macro money flows have a huge impact on the commodity markets that you trade.
One of the most important macro inputs is the U.S. dollar.
Why is that?
Why does the US dollar matter so much for all commodity markets?
In this article, we're going to go through the five reasons that the dollar matters so much for commodity markets. We'll also touch on the two ways that you can incorporate the dollar view into your profitable commodity trading. Let's jump into it.
THE U.S. DOLLAR MATTERS
Our goal at Peak Trading Research is to make you a more profitable trader with commodity market insights and real systematic trading strategies. A big part of profitable commodity trading is knowing how to incorporate macroeconomic inputs into your profitable commodity trading game plan.
And the U.S. dollar is one of the most important macroeconomic inputs to understand.
Let's talk about the five reasons why that is.
Yardstick Effect. The first and one of the most important reasons why the dollar matters so much for commodity markets is what we call ‘The Yardstick Effect.’ Most commodity markets are U.S. dollar-denominated, so if the U.S. dollar drops in value, prices of commodities rise as a function of the unit of measurement shrinking. That is, the yardstick shrinks. So if the value of the dollar drops, commodities are worth more dollars.
Macro Flows. The second reason why the dollar matters so much for commodity markets is because of macroeconomic trader flows. There are a lot of hedge funds that will use commodity futures as a way to express a macroeconomic view. These traders will often buy agriculture futures as a way to profit from the value of a falling U.S. dollar. This is sometimes referred to as ‘trading the U.S. dollar in the Wheat pit’, i.e., using commodities as the instrument of choice to express a view on the U.S. dollar.
Correlation Flows. The third reason that the dollar matters so much for commodity markets is because of correlation flows. There are a lot of systematic and high-frequency hedge funds that see the value of the dollar dropping and act quickly to buy commodity futures. These traders act really quickly - often in just a matter of seconds - to try and buy and sell commodities to front-run other fundamental flows. If these traders think the value of the U.S. dollar is going to drop, they are quickly buying commodity futures to profit from a rise in prices.
Fundamental Demand Response. The fourth reason that the US dollar matters so much for commodity markets is a fundamental reason: a fundamental demand response. Non-U.S. importers (countries and corporations outside of the U.S.) see a weak U.S. dollar as an opportunity to buy cheaper U.S. agriculture products.
One of the best examples of this is in Egypt. The government has set up a program called the General Authority for Supply Commodities, also known as GASC. Buyers at GASC are constantly looking around the world to see where they can source the lowest priced Wheat to bring home to feed the Egyptian population. So if the U.S. dollar is weak versus currencies in origins like Russia or Australia or Canada or Europe, naturally GASC will buy more U.S. dollar-denominated Wheat from the United States. If the dollar goes down, U.S. dollar-denominated Wheat goes up.
Fundamental Supply Response. The fifth and final reason that the U.S. dollar matters so much for commodity markets is another fundamental reason: a fundamental supply response.
For a good example of this, put yourself in the shoes of a Brazilian farmer or an Argentine farmer. If you see a weak U.S. dollar and a strong Brazilian real and a strong Argentine peso, you know that if you sell your Soybeans into the global market at a dollar price, you're not getting a whole lot translated back into your local currency.So if you see a weak US dollar, you're not going to export your Soybeans, you're going to put them in silos or put them in bags, you're going to sit back and reduce your exports. You're going to reduce the amount of supply in the market. And you’re also probably not going to plant as much. You're not going to expand your acres if you see a weak U.S. dollar and a weak global price for your Soybeans.
In summary, a weaker U.S. dollar means fewer South American exports and less South American acreage expansion, all of which leads to higher prices via reduced supply.
TRADING
To summarize, there are five reasons that the U.S. dollar matters for commodity markets: the yardstick effect, macroeconomic trader flows, correlation trader flows, fundamental demand response, and fundamental supply response.
We've established that the U.S. dollar matters for commodity markets for a lot of fundamental and non-fundamental reasons, but how can we make this actionable?
How can you take a U.S. dollar view and incorporate it into your profitable commodity trading game plan?
ORIGIN CURRENCIES AND DESTINATION CURRENCIES
The first way to do this is by understanding which currency markets are most important for the commodity market that you trade.
A lot of this has to do with looking at origins where the commodity is mined or grown and destinations where the commodity is imported.
For example, if you're a Soybean trader, you need to focus a lot on the Brazilian real or the Argentine peso where Soybeans are grown, and you also need to focus on the Chinese renminbi, because China is the world's largest Soybean importer.
Every commodity market is unique, but all follow that supply and demand framework, so you should think about origin currencies and destination currencies.
Key currencies to watch in the soybean market
CENTRAL BANK POLICIES AND ECONOMIC REGIMES
Another way that you can incorporate a dollar view directly into your trading is to analyze what kind of economic regime we're in.
For example, is U.S. data improving enough for the US Federal Reserve to start removing stimulus?
As the US Federal Reserve starts tapering its quantitative easing purchases and eventually starts raising interest rates, that will strengthen the U.S. dollar.
We last saw this in 2014. The last time the Fed was tapering their QE purchases, the US dollar rose and commodity prices fell.
BOTTOM LINE
Think about the currency pairs that matter most for your market.
Is it the Australian dollar or the Brazilian real or the Chinese renminbi?
And analyze the current economic regime, what central banks are doing, how data is performing, and how that might move the dollar over the months and quarters and years to come.
Hopefully, this article helps you understand the different ways in which the U.S. dollar impacts your commodity markets and how to use a U.S. dollar view to trade commodity futures more profitably.
If you're interested in live updates of the macroeconomic inputs that matter most for your commodity markets, you can reach out to us for a trial of our research: Insight@PeakTradingResearch.com.
