Interest Rates and Commodities explained by professional Forex trading experts the “ForexSQ” FX trading team.

Interest Rates and Commodities

Commodity prices go up and down for many reasons. Each commodity has its own supply and demand fundamentals. However, commodity prices are an asset class on their own. Therefore, macroeconomic factors most certainly affect prices and at times, the entire commodity sector follows the same value path. The U.S. dollar is the reserve currency of the world; generally, a stronger dollar will cause commodity prices to move lower and during periods of dollar weakness commodities tend to move higher.

Currencies are sensitive to moves in interest rates as are commodity prices.

In 2008, a global financial crisis caused central banks around the world to take a proactive stance as they attempted to shield the financial system from the shock of the crisis. In the years that followed these monetary authorities lowered interest rates in attempts to stimulate spending and economic activity. After all, low interest rates encourage borrowing and growth. It also entices individuals to spend money rather than leave it in saving accounts that provide a very small yield, thus providing an increase in consumer spending.

During the period of declining interest rates after 2008, commodity prices took off like a moon shot. Many made all-time highs as raw material prices rallied in the aftermath of the crisis. Gold traded to highs of around $1920 per ounce, copper traded to over $4.60 per pound and many other commodity prices participated in the secular bull market that peaked in 2011.

One of the major reasons for the strength in raw material prices was ever declining interest rates in the United States and around the world. Lower interest rates create cheap money. Commodities rallied for two reasons. First, low interest rates decrease the cost of carrying and financing inventories.

China, the world’s largest commodity consumer took this as an opportunity to increase strategic stockpiles of the raw materials needed to build infrastructure. The second reason is that low rates of interest increased inflation fears as a potential backlash of cheap money. Inflation lessens the purchasing power of paper currencies. The bottom line was that decreasing interest rates fueled the great secular bull market in commodities that peaked in 2011.

After 2011, the commodity markets started to figure out that interest rates could not go much lower. In the U.S., a Fed Funds rate of zero was at rock bottom. Since 2011, commodity prices turned around and started moving lower. Over the past few years, many commodity prices made lower highs and lower lows. A sharp rally in the U.S. dollar, which is the reserve currency of the world and the pricing mechanism for commodities, contributed to the decline in commodity prices starting in 2014. Late in 2014, the U.S. central bank began talking about raising the Fed Funds rate. The prospect of higher interest rates on the world’s reserve currency caused raw material prices to fall further.

Interest rates in the United States and around the world are at very low levels.

They really have nowhere to go from here but up. This does not bode well for the price of commodities at the current time. The Federal Reserve will eventually raise rates and this will mean it will cost more to carry inventories, which will add additional downside pressure to the bear market in commodity prices. A higher real interest rate in the United States is likely to have a negative effect on raw material prices.

So many different factors affect the price path of commodities. Weather, supply and demand fundamentals, demographics, currency moves and other exogenous events all are important inputs when analyzing or forecasting future prices. Interest rates are just one more of these inputs. Since interest rates have fallen to levels that are historically low, common sense tells us that there is a lot more upside than downside when it comes to interest rates these days.

This could mean that the great commodity bear market that started in 2011 has a way to go on the downside. Perhaps we will eventually see inflationary pressures because of many years of low interest rate or cheap money policy. That is likely to cause the next cyclical bull market in raw material prices.

Interest Rates and Commodities  Conclusion

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