Last year, in preparation for my July Capitol Hill testimony on the role of pension and index investing in the commodities market, I examined the much discussed relationship between the dollar and commodity inflation. I never published the work although I shared it privately with a few people involved in the policy debate. Frankly, I thought the bursting of the commodity bubble and the reversion to costly (from the standpoint of long indexers) contango markets would demonstrate the ultimate problems with viewing commodity futures as an asset class, but apparently here we go again…
With the short dollar/long oil trade once again rearing its ugly head, I thought it would be worthwhile to put the work out there with the write-up I did at the time. I concluded that the correlation was due to the financial trade rather than fundamentals. I was tentative in my assessment then, but feel more strongly about now with the benefit of hindsight.
I do believe that over the long term we are in for a good run of fundamentally justified hard asset inflation. However, some (not all) of the current runup in oil reflects the influence of financial players in the market place — once again, this market is becoming overspeculated with the “tail wagging the dog,” as financial flows overwhelm fundamental concerns. A renewed tight inverse relationship between the dollar and oil is evidence of this problem, not a rationale for the continued distortion of our commodity markets. Here’s what I wrote up then:
The Dollar and Commodities
June 20, 2008
Observers of commodity inflation often point to dollar weakness as a critical component of the price increases. While currency movements are an important factor in commodity pricing, it is only one of many influences. We use the $/Swiss Franc as a proxy for broad currency moves, since actual trading data for this preexists the Euro. We compare the Dollar/Franc series to the Goldman Sachs Spot Commodity Index both in aggregate since 1987, and broken into discreet 2-year increments. This produces some surprising results. For one, the correlation between commodities and currencies has not only been weak historically, it has also changed direction at times. This suggests that commodity pricing is generally dependent on a multiplicity of factors. More puzzling is the very strong correlation which has developed over the last 18 months. One possible explanation is that, given that this period coincides with an explosion of investment (index speculation) capital in the futures markets, commodity pricing is being driven by factors divorced from traditional physical supply and demand considerations.