The rise in commodity prices over the past two years, dominated by energy, has had a profound effect on world economies and markets. It has been the primary driver of the increased inflationary pressures that have caused numerous central banks to tighten policy despite the credit crunch, has weakened growth in many economies, and has seen a massive income transfer from consumers to producers.

In the foreign exchange (FX) market, the major beneficiaries of higher commodity prices have been the Canadian Dollar (CAD), the Australian Dollar (AUD) and the Norwegian Krone (NOK), whilst the main loser has been the American Dollar (USD). The Euro (EUR) also seems to benefit from higher commodity prices, though through their impact on inflationary expectations and European Central Bank (ECB) policy.

Over the past few weeks, commodity prices have fallen quite sharply. Is this reversal likely to continue, and, if so, what will be its effects on the FX market? There is a sufficiently large speculative (or at least financial) element to the acceleration in prices since last August to suggest that a further downward correction is likely. If so, the main winner in the FX market will be the USD and the biggest losers are likely to be CAD, AUD and NOK. The EUR will also likely suffer a reversal in these circumstances as ECB policy focus shifts from upward inflation pressures due to commodity prices towards downward pressures from weakening economic activity.

The spreading impact of the credit crunch over the past year has been increasingly seen in weakening confidence and activity levels in the largest western economies. At the same time, commodity prices have been moving sharply higher, with an especially sharp acceleration since the beginning of this year.

The fundamental case for higher commodity prices is well known and widely acknowledged. Most of the growth in the world economy is coming from the rapidly expanding emerging markets such as China, India and Brazil. These economies are intensive users of commodities, so global demand will be increasingly high.

At the same time, the growth of supply, especially in energy and agriculture, has been limited by low levels of investment and by political factors. Hence, the argument goes, commodity prices will continue rising even if demand from the industrial economies weakens.

Is all of the rise in commodity prices entirely due to the fundamental forces of physical supply and demand, or has there been a speculative element which may be in the process of unwinding? Central bank officials certainly do not see speculation as an important element. For example, in his recent Monetary Report to Congress, the Federal Reserve chairman Ben Bernanke said: "However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year."

If the reversal in commodity prices seen in recent weeks is extended, what will be the FX consequences?

It is not surprising that the CAD, AUD and NOK are the biggest winners as they are widely perceived as 'commodity currencies'. The USD is by far the biggest loser.

The effect is probably exaggerated, given that the dollar was falling for plenty of other reasons than rising commodity prices, but it does seem genuine. The EUR also seems to benefit from higher commodity prices. However, this rather seems to reflect the influence of commodity prices on perceptions of the way the ECB will act.

The reason the EUR has benefited from rising commodity prices appears to be that the more commodity prices rise, the more the ECB worries about second-round inflation effects, and the more likely it is to raise interest rates. There is no doubt that ECB thinking has become more focused on commodity prices in recent months. Should commodity prices continue to decline, then the ECB focus would probably start to shift away from the risk of second-round inflation effects, and towards the impact of rapidly weakening economic conditions in the Eurozone.

There are reasons to believe that the current correction in commodity prices has further to run. If this is the case, then we should expect to see CAD, NOK and AUD under-perform.

In addition, such an environment would almost certainly be positive for the USD and negative for the EUR, mostly because of what it might imply for ECB policy. Overall, a deeper correction in commodity prices would very likely see the dollar rise against all its G10 counterparts.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.