Rising Interest Rates Tend To Be Bearish For Commodities

It had been many years since the Federal Reserve in the United States moved interest rates higher. The housing crisis of 2008 and the global economic issues that followed forced the U.S. central bank to embark on six years of lowering interest rates and a policy of quantitative easing. While the U.S. economy improved starting in 2015, the rebound led the rest of the world. Lethargic economic conditions in Europe caused the European Central Bank to institute a quantitative easing program of their own in early 2015.

While interest rates in the U.S. fell to zero percent at the lows, European rates fell to negative levels in some nations and remained there in early 2017.As of the beginning of 2017, the U.S. Federal Reserve had increased the Fed Funds rate twice which were the first rate hikes in many years. Additionally, the U.S. central bank guided markets to expect at least two more rate hikes in 2017.

In China, an economic slowdown caused the Chinese central bank to lower interest rates as the country struggles to achieve a growth rate of 7%, so far it has fallen short of that level. In Russia, a combination of sanctions imposed by the U.S. and Western Europe and low raw material prices had caused the Russian economy to weaken. In Brazil, Australia, Canada and other commodity producing nations, lower prices had decreased revenues causing their currencies to plunge in 2015. However, higher commodities price since the late 2015 and early 2016  caused a rebound in many commodity-sensitive currencies.

 

The bear market in commodity prices that began in 2011 when raw material prices peaked, had been the result of many economic pressures on the global economy. As China slowed, demand for commodities decreased. China, by virtue of its population and growth, is the most important nation in the world when it comes to raw material demand.

Moreover, the U.S. dollar is the reserve currency of the world and as such, it is the pricing mechanism for most raw materials. Moderate growth in the U.S. caused the dollar to begin to strengthen starting in May 2014. By March of 2015, the dollar had rallied by 27%. In late 2016, the dollar rose to a new high, the highest level since 2002 before correcting lower during the first month of 2017.

Prospects for U.S. interest rate increases means that the dollar will have a higher yield than other competing currencies. Higher U.S. interest rates combined with moderate growth in the U.S. economy is supportive of the dollar. The U.S. central bank was in a tightening cycle that began in December 2015 with two rate hikes of 25 basis point since. The Fed has warned markets of a likelihood of additional short-term rate increases in 2017.

A rising dollar is generally bearish for raw material prices. A rise in interest rates is also a negative factor for commodities. When interest rates rise, it costs more to carry or finance long positions or inventories of commodities. Therefore, consumers and buyers of raw materials become less likely to hold inventories. One of the reasons that commodity prices increased between 2008 and 2011 was the low level of interest rates in the United States.

This had depressed the value of the dollar and caused financing rates to plunge in an attempt by the central bank to stimulate the economy.

Now that interest rates are rising in the U.S. commodity prices could see some downside pressure. In early 2016, copper traded to lows of $1.9355 per pound before recovering later in the year. However, in 2008, copper traded just below $1.25 and in 2000, the price was around the 85 cents per pound level. In December 2015, gold fell to the lowest price since February 2010 when it traded to $1045.40 per ounce. In 2008, the high in gold was at just under $1035 and in 2000; the price of the yellow metal was under $300 per ounce.However, gold had posted impressive gains in the months that followed the December 2015 lows.The price of crude oil plunged from over $107 per barrel in June 2014 to under the $26.05 level in February 2016.

In 2008, crude oil fell to lows of $32.48 and in 2000; the price was below $25 per barrel.  In early 2017, the price of oil was double the February 2016 lows. While higher interest rates could threaten impressive price gains since the late 2015 and early 2016 lows, rates are just one of many factors that determine the path of least resistance for commodity prices.

There are many issues that that drive commodity prices higher or lower over time. An economic slowdown in China, the world's most populous nation, can impact demand. Rising interest rates in the United States tend to cause the dollar to strengthen which can put more pressure on commodity prices. The higher cost of financing commodities in dollar terms can a bearish sign for raw materials. However, if rates are rising because of an increase in inflationary pressures on the U.S. or global economy, the prices of commodities can rise alongside rates. Therefore, it is the level of real interest rates that can have a bearish effect on commodities when they move higher and inflation can be a very bullish signal for raw materials. 

While rising interest rates can be bearish for commodity prices, there are many other considerations when it comes to the path of least resistance for prices in this volatile asset class.