How Markets Interact, Part 2: Commodities

Commodities are probably the easiest markets to understand. They are comprised of products and materials which are so basic that they generally are bought and sold at one standard price set by the open market. Some examples of commodities are oil, natural gas, gold, silver, corn, wheat, rice and live cattle.

Futures contracts, the means by which commodities are bought and sold, allow buyers and sellers, called hedgers, to lock in future prices. They also allow speculators to attempt to profit from fluctuations in prices. In any event, the prices of commodities are set by this trading in the futures markets.

As I said, commodities are fairly easy to understand. If prices of commodities overall are rising, that is indicative of inflation. Falling commodity prices are indicative of disinflation, or even deflation. Said another way, commodities signal expectation of economic expansion or contraction. If commodity prices are rising, that shows an expectation among investors that demand, hence prices, will be higher in the future. If they are falling, investors are voting that economic contraction is coming. What’s interesting is that this tends to be self-fulfilling. Rises and falls in market prices both signal and help bring about rises and falls in economic activity.

When currencies rise in value, commodities prices tend to fall. This makes sense, because if currencies increase in buying power then the amount of currency needed to buy things, and hence the price of those things, decreases.

In the case of the U.S. dollar, this relationship between currency value and commodity price is often more pronounced. This is most dramatically seen with oil. Since the price of oil is measured internationally in U.S. dollars, when the dollar falls the increase of the price of oil is immediate, and vice versa. As I write this the price of oil is at a multi-month low and the dollar is at a multi-month high. This is no coincidence. When oil prices are rising, most likely the dollar is falling.

Some currencies are called commodity currencies. This means they come from countries whose economy is directly tied to particular commodities, because they major in the production of those commodities. Canada (oil) and Australia (gold) are both examples of commodity currencies. In the case of commodity currency countries, the relationship between the value of the currency and the price of the commodity is direct instead of inverse. Generally speaking, when the prices of their respective commodities rise, so does the value of their respective currencies. This is because instead of buying these commodities, they sell them. So buyers, in order to buy the commodities, must convert their currencies into the exporting country's currency, that is buy the currency. So they buy the currency first, then use it to buy the commodity. This drives the price of both up. Another way to look at it is that the flow of money into the exporting country enriches the country, and so adds value to its currency.

Next up: Bonds.