Commodities keep market afloat

A crumbling dollar helped spur this year's commodity price surge, but a rebound in the US currency now does not mean necessarily that prices of industrial metals or oil will decline.

Increasingly the focus is on tightening supplies of raw materials and on escalating demand, particularly in China, India and other emerging economies.

The only commodity expected to come under significant pressure from any further recovery in the dollar is gold, which is used as a currency substitute and a financial instrument in much the same way as stocks and bonds. "The reason why the gold price has not gone up despite the rise in the oil price is because the dollar strengthened," said Stephen Cohen, managing director at fund firm Troika Dialog.

Gold is often used as a hedge against inflation, which is often triggered by rising oil prices.

"Other commodities are different, they are going to be a function of their own supply and demand," Cohen said. "There are problems with mines in South Africa and in Chile, problems with oil in Nigeria and declining output in Mexico and Russia."

These difficulties coupled with perceptions that Opec has little spare production and expectations demand will stay strong, boosted prices to a record of $126.98 a barrel last Tuesday.

"People have realised how inelastic global demand is in a period when supply capacity is not increasing," said Bob Greer, executive vice-president at Pimco.

Trend

The dollar is trading at around $1.54 to the euro. It hit an all-time low against the euro beyond $1.60 on April 22, a move fund managers said was overdone because other markets were already starting to price in a correction.

Spot gold is down more than 15 per cent since peaking at $1,030.80 an ounce on March 17. But benchmark London copper has lost about seven per cent since touching a record high of $8,880 a tonne on April 17.

The influence of the weak dollar behind rising commodities higher has been partly because these markets, once the province of producers and consumers, have been invaded by traders and investors speculating on short-term trends.

Used to reacting to economic data, they have seized the idea that a weaker US currency makes commodities denominated in dollars cheaper for holders of other currencies.

Sustained dollar weakness also means producers with dollar revenues and local currency costs try to protect profit margins by raising prices. "For me, the correlation between the weakening dollar and strength in commodity prices does have some justification," said David Dugdale at MFC Global Investment Management.

"The other (indirect) reason for strength is that Asian countries' pegs to the dollar mean that they're effectively following the loose monetary policy of the US, with consequent positive impact on growth and appetite for commodities."

Countries that have fixed their currencies against the dollar have to loosen monetary policy in line with the United States, otherwise their currencies will strengthen.

Fund managers say the strong relationship between the dollar and commodities in the short term should not detract from the argument that in the long term fundamentals will prevail. "The dollar has been going down for the best part of 50 years," said Andrew Cole, director of asset allocation at Baring Asset Management. "The fact is that until a few years ago, commodity prices also went down."

Just as dollar weakness has been an excuse, for some, the dollar's relative strength is now a reason to push commodities higher as it implies economic recovery and strong demand. "We think the reason the dollar is not falling at least temporarily is because of the expectation there will be a recovery," said Evan Smith of Texas-based US Global Investors.

But he said that too steep and rapid an oil price rise could bring prices lower as demand would be eroded.

Equally, too deep a fall in the dollar could undermine commodity strength because it would signal economic weakness and lower consumption.

"If the US goes into deep recession, there's no way commodities can continue their journey uninterrupted," said Ashok Shah, chief investment officer at London & Capital.