Which is the cart, which the horse? All economists know a strong US$ means weak commodity prices and vice versa, even if the precise mechanics are not wholly understood. The dollar is currently near record highs against major currencies, a situation at odds with similarly buoyant commodity prices. Is a reverse in the US$'s strength on the cards? What would it mean for commodity producers?
Producers are currently enjoying a hay day. The rally in mining shares (up 40% in a year) and the oil Majors' resurgent Q1 earnings both indicate the same thing - margin recovery after a deep down cycle.
There are three elements to the bounce. First, self help - all producers have cut costs hard. Second, higher prices - oil is up 40% on a year ago; and though mining commodities are more mixed, generally the suite is higher y-o-y. Third, currency - the continued strength in the dollar is a boon for producers outside the US with costs denominated in local currency.
This serendipitous combination is good news for companies and investors, expanding margins and making dividends that little bit safer.But is this as good as it gets?
The commodity rally of the last year has been driven by fundamentals. Relatively robust global economic growth, China and the US to the fore, is supporting demand growth. There is plentiful supply capacity in most commodities but there have been production constraints. Julian Kettle, our Vice Chairman of Metals and Mining, points price responses sparked by closures of lead and zinc mines; strike action in copper; and OPEC's production cuts in January 2017. Aluminium, nickel and coal markets remain lacklustre.
The hair-trigger sensitivity of certain commodities to supply disruption suggests the tentative, very early stages of a cyclical recovery.
But it's a recovery that may take some time to play out. Our Global Analytics team thinks 2015/16 will prove the low point of the commodity cycle. It may be 3-5 years before the fundamentals of most markets tighten sufficiently for a sustained bull run.
The dollar may now be close to peaking after a six year unbroken run. The correlation with commodities has been strong since the Great Financial Crash in 2008. The Fed's stimulus packages weakened the US$, and commodities soared. The subsequent sell off in mining commodities from the 2011 peak triggered the initial rebound in the US$, which was then propelled to new heights after oil collapsed in 2014 and QE came to an end.
The US$ is now 25% above the TWI low of 2011, and any chartist would suggest that the risks are on the downside. The current rally in commodity prices from the 2015/16 lows may presage coming weakness.
For now, though, the US$ is still a safe haven - there are plenty of economic or geopolitical banana skins around the world.
But beyond 2018 the outlook is less rosy. Our Macroeconomics team forecasts the dollar will revert from the current cyclical high to 'long term equilibrium' rates with other major currencies over the next 3-5 years. This implies a fall in the US$ TWI of up to 20%.
What are the medium term implications for producers? A new upcycle in commodity prices is bullish for companies across the board. Few sectors are more responsive to a change in price signal. But any weakening of the dollar will temper the benefits for some producers. There will be relative winners depending on the proportion of costs that's US$/local currency denominated.
US producers in any commodity would be winners, ditto Canadian and Mexican producers. Tight oil operators, for example, had no US$ cost offset when oil prices halved in 2015. The subsequent slashing of costs to protect margins stands them in good stead - any rise in oil prices will feed straight through to margins net of cost inflation. The last point is a risk factor for all producers as prices rise.
At the other end of the spectrum are commodity producers with local currency costs.
Miners and oil and gas producers in Russia, Australia and Brazil among many others enjoyed a soft landing as the local currency also dropped when commodity prices fell. The upcycle will see the reverse: a weakening US$ will take the edge off any commodity price rally.