WHY DO COMMODITIES TEND TO MOVE INVERSELY TO THE U.S. DOLLAR?

By: Sean Ryan

Commodities tend to move inversely to the U.S. Dollar because, at the most fundamental level, commodities are valuable in and of themselves (porkbellies, or barrels of oil, or gold) while U.S. Dollars are simply pieces of paper, with no instrinsic value beyond their backing by “the full faith and credit” of the U.S. government.

Currencies backed by nothing but the “full faith and credit” of the issuer are known as “fiat money ‘ – they are only valuable because the issuing government declares them to be so, and because markets accept that declaration. The degree to which markets accept it is not set in stone, however. Markets can gain or lose confidence in the value of fiat money based on economic, or even military and political factors.

As a result, inflation affects Dollars and commodities differently. When inflation rises, it erodes the market’s confidence in the value of the Dollar; a Dollar can purchase less than in the past. Conversely, most commodities are traded in U.S. dollars (even when they are traded outside the United States like, for example, oil), so if the value of the dollar is falling due to inflation, then commodity prices will tend to rise. Inflation means the Dollar buys less, and commodities are among the things the Dollar buys less of.

It’s very simple if you imagine the most extreme scenario possible. If people lost all confidence in “the full faith and credit” of the U.S. government, then Dollars would literally be worthless scraps of paper. Commodities, however, would still be very valuable; evening a “Mad Max” world in which Dollars were good for nothing but kindling, porkbellies would provide bacon, and oil would provide gasoline, and they could be traded for other goods and services.

Rising or falling inflation expectations merely represent baby steps toward or away from that hypothetical extreme case.

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