The market has prepared itself for the US Federal Reserve to increase the short-term Fed Funds rate for the second time in 10 years over the coming months. Markets have not dreamed this up; the central bank has done its best to inform anyone who was listening over recent weeks.
After the financial crisis of 2008, the Fed and other central banks around the world embarked on programs of lower interest rates and quantitative easing or buying debt to stimulate borrowing and spending and inhibit savings to jump-start economic conditions. QE ended in the U.S. in late 2014 and the central bank began to prepare markets for accommodative monetary policy to change gears and move into a tightening cycle. While there were many rumors of an imminent interest rate hike and "liftoff" from zero during 2015, markets had to wait until December for the Fed to finally act. When they announced the increase in the short-term rate, the central bank told markets to expect 3-4 more hikes in 2016 as they had entered into a tightening cycle.
2016 began with a bang as Asian markets cascaded lower and equity markets around the world followed in what was Asian Contagion. Then, economic growth in the U.S. became choppy giving the central bank more reasons to pause. In June, the United Kingdom shocked the world as its citizenry voted to leave the European Union in a referendum that resulted in more market volatility. As of the end of August, the Fed Funds rate remains at the same level it was at on December 31, 2015. With the upcoming Presidential election on the horizon in early November, many market analysts believed that the Fed would remain in neutral but central bank officials recently told markets to prepare for another rate hike soon as economic conditions have become ripe for a second round of tightening.
In the wake of the hawkish talk by Fed officials, the stock market has paused, and commodities prices have corrected lower after some spectacular price gains over recent months.
The inverse relationship between the dollar and commodities
The dollar is the world's reserve currency. The status as a reserve currency means that other nations around the globe hold dollars as part of their foreign exchange reserves. In fact, the dollar has been the primary reserve currency for decades as the United States is the world's largest economy. Dollars are a means of exchange that are acceptable to almost all governments and people on earth, and the U.S. currency is the pricing benchmark for virtually all commodities.
As a result of the dollar's dominant role in world trading, when the dollar increases in value against other foreign exchange instruments, the prices of commodities in other currencies rise when dollar-based raw material prices are stable. The bottom line is that it takes more of the other currencies to purchase the same amount of a raw material asset during periods of dollar strength. Conversely, when the dollar loses value against other currencies, commodity prices tend to rise in dollar terms as it takes less of those foreign exchange notes to purchase raw materials, thus encouraging demand around the world. Remember, there are only around 324 million people in the United States where the dollar is the means of exchange out of 7.348 billion people on our planet. Over 95% of the world uses currencies other than the dollar. Therefore, while the U.S. accounts for only 4.4% of the world's population, the currency of the country impacts raw material prices for everyone on earth.
The monthly chart of the U.S. dollar index illustrates the importance of the dollar when it comes to commodities prices. As the chart highlights, the value of the dollar moved lower starting in 2002. At the same time, commodity prices began to rise. The dollar index moved from over 121 in July 2001 to the 70 level in early 2008. The 42% decline in the greenback occurred at the same time that the price of crude oil, perhaps the most ubiquitous raw material in the world, moved from $20 per barrel in 2001 to highs of $147 in 2008, an increase of 635%. The example of the crude oil price increase that corresponded with the falling dollar is extreme. However, many other commodity prices posted similar gains as the dollar dropped. Copper moved from 80 cents per pound in 2001 to over $4 per pound in 2008, and there are many other examples.
Commodities are volatile assets and currencies tend to be stable. Therefore, trends that develop in the dollar versus other currency instruments can exacerbate moves in commodities. More recently, the dollar began to rise in May of 2014, and it moved from under 80 to the 100 level on the index. During that period, many commodity prices dropped to multi-year lows reaching their nadirs in late 2015 and early 2016 as the dollar stabilized and began to trade in a narrow range.
The relationship between the dollar and commodity prices is an important consideration when analyzing the path of least resistance for raw material values. Meanwhile, the dollar is highly correlated with interest rate differentials around the world and now that the Federal Reserve is in a tightening cycle the risk of a stronger dollar weighs on the future price path of many commodities. If the Fed hikes rates at their September or December meetings, or both, the likelihood is that the dollar will strengthen against other major currencies, and many commodity prices will fall. When it comes to the relationship between commodity prices and U.S. dollar interest rates, there is often a double-whammy effect when rates increase in the United States.
The inverse relationship between interest rates and commodities
Aside from the fact that higher U.S. interest rates tend to cause the dollar to increase in value, those higher rates also increase the cost of carry for commodity inventories. There are two ways that this happens, directly and indirectly. For those who finance stockpiles of raw materials, it costs more to hold commodities in storage each day when rates rise. For those who employ their capital to buy these assets, there is an opportunity cost as the money spent for the commodities would earn a higher rate of return if held in fixed income instruments. Therefore, higher interest rates are bearish for raw material prices and there is an inverse relationship between financing rates and commodity prices. Higher rates encourage consumers to purchase requirements on a hand-to-mouth basis rather than holding these necessary staples on a ready-to-use basis.
The Fed promised 3-4 interest rate hikes in 2016 back in December 2015 when they increase the Fed Funds rate for the first time in nine years. Concerns about economic growth, contagion from weak economic conditions in Europe and Asia and political issues around the world such as the surprise Brexit referendum results from the U.K. has caused the Fed to pause. However, recent comments from the central bank indicate that they are ready to move and increase the short-term rate for the first time this year. Commodities prices began to rise as the Fed paused throughout 2016 and recently the words of the Fed have caused a correction to the downside in many raw material markets.
When rates increase, fixed income instruments pay a higher yield and become more competitive when it comes to attracting capital. That is why recent comments from the Fed have caused the stock market to stop in its tracks and many commodity prices to drop over the past week. Precious metals prices have all lost ground, crude oil has fallen, and many other raw material assets have moved lower from recent highs with the prospects of a rate increase by the world's most influential central bank - the Fed. Now markets are prepared for the Fed to move, they have spread the rumor and noise about a rate hike, and markets have taken them at their words. The thing about central banks is they are cautious. The Fed has stated that they depend on economic data and the next piece of data, the one that may push them over the cliff when it comes to increasing the rate, was last Friday's employment report. The Fed has told markets that there are three important data points they watch the inflation rate, economic growth and employment trends in the United States.
Friday's employment report
The August employment report tends to be the weakest of the year as summer vacation is a time of year when many businesses curtail hiring. Therefore, market expectations for the report were for an increase of around 180,000 jobs. On August 31, the ADP employment report showed an increase of 177,000. However, a revision of the prior month's number from 179,000 to 194,000 demonstrates some strength in the labor market. The ADP report is a precursor to the Labor Department's non-farm payroll report. However, at times it has not been an accurate forecaster of the NFP report.
When the Labor Department announced an increase of 151,000 new jobs last Friday, the news was slightly lower than market expectations and the market was left scratching its collective head. The report was not as strong as the Fed would have liked, but it was not as weak as in past years. Now they Fed has the latest data to make a decision at the next FOMC meeting, but they have another issue to contend with - the presidential election that will decide a new chief executive for the United States that comes just six weeks after the Fed convenes.
U.S. rates are still historically lower, even after a hike
As the Fed committee members go into their next meeting at the end of September, they will have the weight of the markets on their shoulders. The employment report was a non-event. Economic growth is moderate. There is still uncertainty and fear in the world as Europe and Asia remain on shaky financial ground. The current level of the Fed Funds rate is 25 to 50 basis points. A rate hike of another 25 basis points is massive on a percentage basis but in the scheme of things it is a tiny and symbolic increase that will leave the Fed Funds rate within striking distance of all-time lows. The last thing the central bank wants to do is to raise rates and after some unforeseen shock to markets that follows to have to turn around and lower them once again. I believe that the Fed will pause in September and act at their December meeting. Even if they do move, the effects of the rate hike have already filtered through markets and it is unlikely that all hell will break loose. There are too many other issues facing markets that are more likely to make that happen.
Meanwhile, higher rates will cause the dollar to remain high, increase the cost of carrying commodity inventories and cap any rallies in many raw material markets in the weeks ahead. There are many moving parts when it comes to the path of least resistance for raw material prices. The chief determinate of any commodity's price is the supply and demand balance of that raw material market. Weather, demographic trends, geopolitical events, economic forces, natural disasters, war, policy changes and many other factors all work together to determine the price of each staple. Interest rates are important, but they are only one piece of a much larger puzzle.
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This article was written by
Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup.Over the past two decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.