Commodity inflation

An important link between interest rates and currency values is commodity inflation, which, unlike an individual area or country’s business activity, affects all economies. As inflation rises and prices spiral upward, some people quickly start to buy up future supplies of basic necessities as insurance against higher prices in the future. In that scenario, prices go up not because of healthy business activity but because of uncertainty and fear-and fear moves markets. In that scenario the government can increase the interest rate earned on cash deposits to get individuals to sell off their stockpiles of supplies in exchange for cash and the increased dividend created by higher interest rates. This seems a responsible action but does not work in all cases. Some individuals are inclined to hang on to their supplies rather than take the cash, and attempts at easing inflation can be thwarted.

Commodity inflation

Businesses and economies around the world wrestled with a very similar fundamental problem with the supply of crude oil from 2005 through 2008. Crude supplies were shrinking as worldwide demand increased, and that caused the price of crude to jump from under $40 per barrel in 2004 to a high of $140 in July 2008. That created additional expenses and commodity shortages and the fundamental complications that go along with that situation. Those problems had not been in place just a few years before. Countries that had their own supplies of crude didn’t feel the need to raise interest rates, whereas some countries and regions that did not have their own supplies did. The interest rate differentials created opportunities for traders but caused much confusion for the economists and politicians charged with solving those complex problems.

Generally, a rise in commodity inflation will cause a rise in the value of the currency of a country that has large supplies of that commodity. Again, however, it is important to keep in mind that currency valuations are relative. Many analysts and commentators called the Canadian and Australian currencies commodity currencies because those countries have an abundant supply of commodities, and as the price of commodities moved higher from 2002 through 2008, so did those two currencies. The United States also has an abundance of commodities, whereas Switzerland does not, yet the U.S. currency went down and the Swiss currency increased sharply over that period. This leads to the question, was there really a relationship between commodities going up and these so-called commodity currencies going up, or did they just happen to be different investment classes that were going up at the same time? As it turned out, the Canadian currency topped out a full seven months before crude oil peaked, whereas gold peaked four months ahead of the Australian dollar. As of December 2008, gold was off its all-time high by just 15 percent and the Australian currency was off its high by 30 percent.

We believe that both commodities and currencies are complex vehicles that should be traded individually on the basis of price movement. There are relationships between different markets and asset classes, but relationships by definition change, particularly when one is comparing complex pricing processes such as commodities and currencies. “Don’t get caught trading wheat in the corn pit” is an old Chicago trading adage. It can be said that the same thing is true when one is trading a currency that is based on a commodity’s price or vice versa.

Commodity inflation overall adds uncertainty to markets as governments try to offset the effects of rising and falling prices with interest rate or other policy changes when often it is best to let the markets correct themselves. Uncertainty in the markets produces price movement, which is always beneficial for traders.