Michael Lewis assesses the chances of continued strong commodity prices and links with the dollar.

Commodity prices have appreciated significantly in the past year. This has in part reflected a regime change in the underlying forces that have affected commodity markets since the 1990s: namely an extended period of low prices that has curtailed new productive capacity, the approaching turn in the US interest rate cycle, the secular decline in the US dollar, rising geo-political risk and more difficult trading conditions in global equity and fixed income markets. Cyclical and structural forces are conspiring to increase the attractiveness of commodity exposure over the medium term.

Powerful interest rate and currency trends will have an important bearing on the fortunes of global commodity markets during 2004. Traditionally, nickel, copper and aluminium have been the best performing commodities to play a turn in the US interest rate cycle. However, speculative activity today is significantly higher than in the previous tightening cycles, as this community front-runs Fed tightening, so price appreciation in 2004 is unlikely to be as impressive as in the past.

Since 1972, the US dollar has exhibited long-term cycles whereby the exchange rate has risen or fallen for extended periods of time. The current cycle of dollar weakness will only become mature after 2006. Traditionally, a weakening dollar has tended to be a positive development for commodity prices, and in particular gold. For the energy and industrial metals markets, it helps to depress commodity prices in non-US dollar terms and typically increases commodity demand outside the US.

Structural imbalance

However, the US trade deficit remains the main structural imbalance in the world economy and continues to pose serious risks for global financial stability. US dollar weakness has so far not undermined powerful reflationary forces. We monitor the nickel/gold price ratio as this has tended to be positively correlated with the 10 year Treasury yield. Nickel’s important input to stainless steel production, which in turn is correlated with global industrial production, means that the nickel price tends to outperform the gold price when global growth is in the ascendancy. Commodity markets since the end of 2001 have been signalling that reflation, not deflation, should be the priority for policymakers as this ratio has risen to its highest level since the beginning of 2000.

However, this could change with a more significant weakening in the dollar. The performance of German and Japanese business confidence when the US dollar was weakening between 1994 and 1995 shows that too much dollar weakness prompts concerns about the ability of the German and Japanese export sectors to compete on global markets and triggers an unravelling in business confidence.

Impact on emerging markets

The impact of rising commodity prices is felt most immediately in emerging market economies, given the fact that a large proportion of the world’s raw materials are located in the developing world. For example, the high share of Chile’s copper exports as a total of merchandise exports has been an important factor behind the appreciation of the Chilean peso in the past year. The difficulty for emerging market economies is that the appreciation in commodity prices is coinciding with a secular decline in the dollar.

A new dimension

Investor interest is adding a new dimension to the traditional fundamental forces that affect commodity prices. The main risk to commodity markets and global financial stability in 2004 is excessive US dollar weakness, which would have a negative impact on global business confidence and hence commodity consumption trends. For as long as the dollar’s decline remains a benign influence on global commodity markets, the upturn in global growth during 2004 is expected to sustain further commodity price appreciation.

Michael Lewis is head of commodities research at Deutsche Bank. These opinions are his own.

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