Does QE Drive Commodity Prices Up? The Demand Perspective
What about from the demand side of the market?
Here, the logic of the mainstream narrative runs along the lines of, “a lower USD boosts demand by lowering the price of a commodity in other currencies”.
How true is this?
Looking at the example from Part 1 again, we know that the second part of this statement is true, a weaker USD does make commodities cheaper in other currencies.
This is reflected in both tables by the price of the commodity in XYZ (Commodity/XYZ) falling as the USD/XYZ exchange rate weakens from 1 to 0.75.
In the first instance, Commodity/XYZ falls from 50 to 37.5, and in the second, from 25 to 18.75. Another way of thinking about this is that when the USD weakens relative to XYZ, XYZ is stronger. Hence commodities become cheaper relative to XYZ.
As for the first part of the statement, consider that the decision to purchase commodities is much more nuanced than merely looking at currency effects.
Traders looking at purchasing commodities as the USD weakens have to be able to answer a few questions, most important of which: Is there end user demand for me to offload these purchases?
Also, do I have access to storage if I want to purchase them now because they are cheap, in the expectation that prices will rise in the future and I can profit? (Which is what is implied by the currency effect line of logic)
Lastly, how much does storage cost for the time horizon I have in mind for the trade, and what is my outlook on future prices?
Now, it is extremely important to remember the economic backdrop within which all of these decisions must be made. If QE is being implemented by the Federal Reserve, that means economic conditions are nowhere near anything that can be considered good.
In this environment, producers are much more likely to be cutting supply as demand for commodities falls in response to deteriorating economic conditions.
In market crashes like 2008 and 2020, commodity prices will fall (quite sharply) first, even as suppliers cut supply in response to cratering demand. Higher prices only come later, after markets regain some degree of certainty and confidence in the future economic outlook.
Hence the major factor at play in higher commodity prices when QE is active really is supply cuts made by producers, not dollar weakness caused by QE.
Sure, dollar weakness could play a part, but ultimately, reduced supply (often drastically) in response to rapidly deteriorating economic conditions at the beginning of downturns is what leads to spectacular price recoveries later on.
Copper and oil in the second half of 2020 provide excellent examples of this kind of rollercoaster price moves.
Remember, correlation ≠ causation!
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