Global Oil Prices, "What's Behind the Drop?" Series: US Dollar Appreciation

Historically, a strong link has existed between commodity prices and value of the US dollar. Falling real (inflation-adjusted) interest rates in the 1970s, 2002-04, and 2007-08 were accompanied by rising real commodity prices; in contrast, sharp increases in US real interest rates, e.g. during the 1980s, send dollar denominated commodity prices tumbling. The relationship between dollar strength and dollar-denominated commodity prices is an inverse one for a number of reasons:

• When the dollar rises in value against other currencies, it makes dollar-denominated assets more expensive for consumers who operate in other currencies, which then stifles demand.
• Higher interest rates also reduce the price of storable commodities by increasing the incentive for extraction today rather than tomorrow, thereby boosting the pace at which oil, for example, is produced.
• Third, portfolio managers respond to rising interest rates by shifting out of commodity contracts (which are now an “asset class”) and into Treasury bills.

The end of the US Federal Reserve quantitative easing program and anticipated increase to short-term interest rates later this year is contributing to an increase in US dollar interbank interest rates. At the same time, the European Central Bank has begun a large scale asset purchasing program in the Eurozone to help the economy. The rise in the US dollar funding costs, however, relative to the euro and other currencies (e. g. Japanese yen) are only serving to further broaden the appreciation of the greenback against its peers.

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