Is it possible we’re entering an environment where food and fuel costs—along with other commodities—will keep rising even as the dollar’s value remains relatively stable? In other words, is it possible to see inflation with a strengthening dollar?
At first glance, a condition like this seems contradictory if not absurd. Most investors, after all, associate inflation with a weak dollar. But as we’ll discuss here, there have been many past instances when commodity price increases have signaled inflation with a strengthening dollar. Moreover, I’ll show that when it does happen, it’s generally a good sign for the economy (and for hard asset investors by extension).
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Recently there has been a lot of concern over the possibility that inflation could become a major problem for the U.S. economy. In May, for instance, Internet searches for the word “inflation” hit a peak level not seen since at least 2004, according to Google Trends (as shown below). This graphically illustrates just how much alarm there is over higher living costs.
Most people tend to think of inflation as a period of persistently rising prices, from raw materials (especially crude oil) to retail goods (particularly food). It’s also commonly assumed that when hard asset prices are on the rise, it’s because the dollar is getting weaker. But that isn’t always the case.
A study published by asset management firm Schroders a few years ago found that between 1990 and 2015, there was an inverse correlation between commodities and the dollar about 60% of the time. But nearly 40% of the time, the dollar and commodity prices rose together, including at various times in 1996-97, 1999-2000 and 2003-2005. Significantly, the study observed that these were times of “both rising interest rates and stronger [economic] growth.”
More recently, a broad basket of commodity prices (including oil and industrial metals) were robust in the last seven months of 2016 despite a rising U.S. dollar index. Commodities were also generally strong in the first half of 2018 which signaled inflation with a strengthening dollar.
Of special interest, during the summer months of 2019, gold prices were 22% higher, while silver was up 37%—and despite a dramatically strengthening dollar. This was just one of many times in the past decade in which gold—which has been called the “ultimate inflation barometer”—and the dollar have (temporarily) traveled in the same direction.
What do all the above-mentioned instances of simultaneous inflation with a strengthening dollar have in common? The answer is that in every case, they occurred in the midst of a central bank tightening policy. That is, the Fed funds rate was increasing while both the greenback and hard asset prices were on the upswing at the same time.
What’s more, the instances when both the dollar and commodities rose together occurred within a fairly vibrant economic backdrop. And as the researchers involved with the Schroders report observed, only if the Fed’s tightening policy proved to be a mistake (as was the case in the mid-to-late 2000s and in 2018) did commodities eventually collapse.
This time around it would appear that we’ve entered yet another one of those strange periods where a we’re seeing inflation with a strengthening dollar. Only this time, the Fed funds rate isn’t increasing. Rather, it’s investors’ anticipation of a Fed tightening policy in 2022 and beyond that is evidently contributing to dollar strength.
The fact that the market can shrug off the Fed’s recent discussions about raising rates can also be viewed as a sign that the U.S. economy is strong enough, for now at least, to tolerate higher rates. And that’s good news for commodity investors, as it should alleviate fears that natural resource prices will be seriously threatened by a stronger dollar.
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Are you worried about current inflationary trends?