18 October 2019
Haul trucks transport iron ore from a mine in the Pilbara region of Western Australia. Falling commodity prices will add deflationary pressure to the global economy. Photo: Bloomberg
Haul trucks transport iron ore from a mine in the Pilbara region of Western Australia. Falling commodity prices will add deflationary pressure to the global economy. Photo: Bloomberg

Will commodities crash trigger new financial crisis?

The equity market has suffered sharp falls in the last two months, and investors are divided on whether the Hong Kong and A-share markets have stepped into the bear territory.

Several commodities like gold, base metal and oil are certainly in the bear market territory. And the meltdown in commodity market may trigger a new financial crisis.

The market predicts that the chance for a “lift-off” within this year has increased to 50 percent from the previous one-third, according to recent remarks by Federal Reserve chief Janet Yellen.

If that is the case, the Fed could open a “Pandora’s Box”, which could further strengthen the US dollar and trigger a further slide in the prices of commodities.

The commodities market suffered its first round of declines in mid-2014, when the United States wound up QE3, its quantitative easing program, and US dollar strengthened.

It can be seen that the market has already started to price in a possible rate hike by the Fed, which has directly weighed on commodity prices.

The US dollar index has moved in opposite direction with most commodities, including oil, metals and the CRB index.

When the US currency becomes strong, commodity prices are suppressed as most of these commodities are priced in US dollar.

The correlation of the US dollar index to oil, CRB index and gold has reached -0.8, -0.79 and -0.54 respectively since 2007.

Therefore, the Fed’s “lift-off” and its rate-hike cycle may further bolster the greenback and drag commodities down.

China’s moderating growth is another key factor behind the weakening commodities.

It remains to be seen to what extent the stock market crash will affect China’s real economy.

The more reliable “Li Keqiang Index” also tumbled to a record low recently, in a sign that China’s economic growth has contracted.

As the world’s second-largest economy, China consumes a substantial amount of commodities. For example, it accounted for nearly 70 percent of global iron ore demand and 50 percent of copper consumption last year.

If commodity prices continue to struggle, the situation could trigger financial and economic problems in emerging markets.

In fact, many of the emerging market currencies have already depreciated considerably since the Fed withdrew its QE3 program, in a sign that global capital is fleeing these regions.

JPMorgan’s emerging markets local currency index has lost nearly 20 percent in less than a year.

That would force many of these emerging economies into a deleveraging process. And the US rate hike may further accelerate capital outflow from these markets.

What makes things worse is that many of these emerging economies rely on commodity exports in varying degrees.

That being the case, any commodity market crash could pose great threat to their economy and financial system or even trigger a new financial crisis.

Meanwhile, a looming deflation and the strong US dollar may delay the US rate hike. The US Fed may not be able to launch the “lift-off” within this year or even deploy a new round of QE next year.

Simply speaking, it’s very difficult for a central bank to make a decision without considering the situation in other parts of the world.

If US decides to hike interest rate this year, the greenback will further strengthen.

The dollar strength may hurt company earnings and the broad US economy, since the eurozone and Japan are set to pump more money into their systems.

Falling commodity prices stemming partially from a stronger US dollar will add deflationary pressure to the global economy, which would in turn limit the room for a US rate hike.

This article appeared in the Hong Kong Economic Journal on July 30.

Translation by Julie Zhu

[Chinese version中文版]

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Hong Kong Economic Journal chief economist and strategist