By Gavin Wendt – 24 August 2017
Commodity prices are rising for a variety of reasons related to both demand and supply-side considerations, however one of the biggest influences I believe the market is currently underestimating is the actions of the US Federal Reserve. I’ll talk more about this in a moment.
Let’s firstly take a look at the recent performance of commodities. Prices were falling during June and early July, as the prospect of higher US interest rates and tighter monetary policy weighed on the sector. Even though the US dollar was weakening in value, most commodity traders were focused more on what was happening in the bond market, rather than the currency. Higher interest rates amplify the cost of carrying commodity inventories.
The price of iron ore, crude oil, gold, silver, copper and a host of other commodities were all heading lower.
Enter the Fed
Enter the US Federal Reserve – which at its July meeting via commentary and actions provided a boost for the commodity sector. The market interpreted the Fed’s statement and actions as ‘dovish’ and therefore bullish for raw materials prices.
The Fed left rates unchanged at their July meeting in a unanimous decision, with speculation that we might not see another rate rise this year. This has in many respects taken the market by surprise, as the Fed had consistently echoed a hawkish tone throughout the first half of 2017.
Since President Trump took office, political realities have slowed his policy agenda and markets have became cautious about his prospects of successfully passing health care, infrastructure and tax reform legislation. This has sapped confidence and led to a softer US dollar.
US Dollar Weakens
Significantly, even though the Fed has hiked rates twice so far in 2017, the dollar has continued to fall against other world currencies. The dollar has been falling since it hit its highest level since 2002 in terms of the dollar index, at the start of January 2017.
Legislative gridlock and multiple personnel changes within the Trump administration have also contributed to the fall in the dollar, although both the president and his treasury secretary have stated on multiple occasions that they prefer a weaker dollar anyhow – as it makes US exports more competitive on global markets and reduces the trade deficit.
The Fallacy of Rising Rates, Rising Dollar
We’ve consistently argued that the conventional wisdom spouted by the media about higher US rates leading to a higher dollar (and therefore a weaker gold price) is wrong. Recent evidence supports our view. The two interest rate hikes so far in 2017 have not caused the dollar to rally, whilst Fed statements about balance sheet normalization have in fact been met with further selling of the greenback.
Of course it’s not about rising rates per se – it’s all about the underlying real interest rate (i.e. the interest rate after accounting for inflation). When real interest rates remain negative, gold tends to thrive.
In fact the data shows that gold prices have been much more likely to rise if interest rates go up than if they stay the same, according to the Federal Reserve Bank of St. Louis. Between 1986 and 2016, the chance of gold rising in the months the Fed raised rates was 55% – whilst the chance of gold being higher 12 months after a Fed hike was 61%.
On average, gold prices have moved 0.7% in months where the Fed hikes, versus 0.4% in months where policy stays the same. The average price change 12 months later is 7.2%.
This correlation can be observed even more recently. Gold prices and the federal funds rate have moved higher in lockstep with one another during the most recent multi-year rate hike cycle between 2003 and 2007. The following chart illustrates that relationship.
The data below essentially shows that a rising interest rate environment in the three decades following the 1950s was the largest precious metals bull market in modern history. Below is a comparison of the Federal Funds rate and gold prices between 1968 and 1990.
Commodities Set to Benefit
A more dovish approach by the Fed, together with a weaker dollar, is a potent cocktail for commodities markets – not just gold. The rally in commodities also corresponds with the International Monetary Fund’s (IMF) latest estimates for world economic growth – it sees the global economy expanding by 3.5% this year, despite a reduction in its US outlook.
The evidence also tells us that July marked the first month so far in 2017 that the Bloomberg Commodity Index (BCOM) (+2.3%) outperformed the S&P 500. Bloomberg analysis shows that the BCOM in fact is showing a similar recovery pattern as 2009, in the immediate aftermath of the GFC.
Summary
Higher commodity prices and a weaker dollar are important inflation indicators that have until this point been notably absent in the recovery so far. A peaking dollar should mark an inflection point for sustained commodity recovery, supported by demand exceeding supply and multiple years of price declines.
Disclaimer: Gavin Wendt, who is a director of Mine Life Pty Ltd ACN 140 028 799, compiled this document. It does not constitute investment advice. I wrote this article myself, it expresses my own opinions and I am not receiving compensation for it. In preparing this article, no account was taken of the investment objectives, financial situation and particular needs of any particular person. Investors need to consider, with or without the assistance of a securities adviser, whether the information is appropriate in light of the particular investment needs, objectives and financial circumstances of the investor. Although the information contained in this publication has been obtained from sources considered and believed to be both reliable and accurate, no responsibility is accepted for any opinion expressed or for any error or omission in that information. I have no positions in the stock mentioned and no plans to initiate any positions within the next 72 hours.
