Friday, October 10, 2014

Putting commodity prices and the dollar into perspective

Falling prices for many commodities, including gold and oil, combined with a rising dollar, have sparked lots of concern of late about whether the Fed is too tight and whether the risk of deflation is once again rising. I think those concerns are way overblown and quite premature. As I see it, most commodity prices aren't weak, they are merely less strong than before. Moreover, the dollar today is not strong, it's merely less weak than before. From my perspective, the strength of the dollar reflects an improved outlook for the U.S. economy, and lower commodity prices reinforce that outlook since they lift a burden from U.S. producers and consumers.

The chart above shows the real, inflation-adjusted value of the dollar against a large basket of other currencies and against a basket of major currencies over the past 40+ years. In the past three years the dollar has risen from all-time weak levels to a level that is still below its long-term average. Three years ago the dollar was extremely weak, whereas today it is merely somewhat weak. This should bring a sign of relief to everyone who conducts their affairs in dollars. For a more detailed look at the dollar's valuation against other major currencies, see my post "The Return of King Dollar" from last month.

The chart above shows the nominal value of the dollar against a basket of major currencies (Euro, Sterling, Yen, Canadian, Swedish Kroner, and Swiss Franc) over the past 8 years. It's jumped up this year, but it's been at this level several times in the recent past. What's happened of late is nothing new or extraordinary.

The chart above compares the value of the dollar (against the same basket of currencies in the prior chart) to an index of spot, non-energy commodity prices. Here we see that there is a decent tendency for the dollar and commodity prices to move in opposite directions (note that the left y-axis shows the inverted value of the dollar): today's stronger dollar is accompanying a decline in commodity prices, and it probably implies further weakness in commodity prices. But nothing in this chart suggests a plunge in commodity prices is necessary or imminent. Commodity prices are still very high compared to where they were in late 2001, and the dollar is still relatively weak.

The chart above compares the price of gold to the price of a basket of industrial commodity prices (excluding energy). The two tend to move together over time, but gold prices are far more volatile (note that the scale of the left y-axis is more than twice the scale of right y-axis). Gold is meaningfully off it's 2011 high, but still far above its 2001 low. Commodities are only moderately off their all-time high. When gold and commodity prices were extremely depressed, back in the late 1990s and early 2000s, the dollar was extremely strong and Alan Greenspan was worried (correctly) about the risk of deflation. That is manifestly not the case today. If anything, weaker commodity prices and a modestly stronger dollar work to reduce the risk of a big increase in inflation.

As for oil prices, the chart above shows that the inflation-adjusted price of oil is still extremely high relative to what it was just two decades ago. Falling oil prices of late have only brought modest relief, so far, to consumers.

But that relief should increase in the near future. The first of the above two charts shows the average price of regular gasoline at the pump. The second chart compares pump prices (the orange line) to the price of gasoline futures (white line), which tend to lead pump prices. Today's gasoline futures prices suggest that pump prices for regular gas should fall to $3.00 or lower within the next week or two. That is good news for everyone who depends on gasoline.

The chart above shows the Journal of Commerce Commodity Index, along with its major subcomponents. Each is indexed to 100 as of the date in late 2001 that commodity prices reached a multi-decade low. Oil and metals prices have both risen by about the same amount, whereas miscellaneous commodities (e.g., hides, rubber, tallow, plywood, red oak) have risen only modestly, and textiles have hardly risen at all. In aggregate, the commodity complex is still trading at relatively high levels compared to just over a decade ago.

The cure for higher commodity prices is higher commodity prices, as they say. Commodity prices became extremely expensive a few years ago, and that sparked a wave of new exploration and production. Increased production combined with weaker economies in China and Europe have halted and reversed that rising price trend, with the result that commodity prices are receding from their extreme levels.

The dollar was crushed three years ago, and now it has managed to recover some of its strength. That undoubtedly reflects the fact that the U.S. economy is doing better than most other major economies (though no one is seeing glory days), and that means that the Fed is likely to raise rates sooner than other central banks will. There's nothing unusual at all about that, and in fact it's another reason to cheer. Things could be an awful lot worse, and they have been.

Moral of the story: markets worry way too much about rising interest rates and deflation these days.


William said...

Today, on the NYSE only 15 new 52 week highs and 443 new lows.

RK said...

I would recommend that you either adjust for inflation in all charts or not adjust for inflation at all. For instance while the oil price is adjusted for inflation, the gasoline price chart is not. The lack of consistency makes chart comparison difficult. Thank you.

Scott Grannis said...

I would note that gasoline prices and oil prices are pretty closely linked, so a chart of real gasoline prices would closely track the pattern of real oil prices.

RK said...

Scott, I found a chart of inflation adjusted gasoline prices here: The adjusted prices are falling in recent years instead of being flat when prices are unadjusted.

WilliamHeadley said...
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WilliamHeadley said...
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