Why commodity investors need not fear the Fed

The conventional wisdom is that the outlook for US interest rates will be critical in determining the prospects for commodity prices over the next few years. Indeed, some commentators seem to base their forecasts (particularly for gold) solely on their Fed view. However, there are many good reasons why prices can rally even as US interest rates are returned towards more normal (but still low) levels.

Starting from first principles, it is not unreasonable to assume that higher interest rates will go hand-in-hand with lower commodity prices, most other things being equal. From an investor's perspective, higher interest rates may increase the opportunity cost of holding commodities. From a consumer's perspective, they may result in slower economic growth, also reducing demand. And from a producer's perspective, higher interest rates will make it more attractive to increase output and invest the proceeds in financial assets for a better return, thus potentially increasing supply.

Moreover, what happens to interest rates in the US may be disproportionately important for global commodity prices. In part this is because of the further boost that Fed tightening might provide to the value of the dollar. It is also still widely assumed that where the Fed leads, other central banks will inevitably follow.

So far, so good. But in practice, the narrative that "higher interest rates = lower commodity prices" is far too simplistic, even for gold. Note first that the principles above apply mainly to real (that is, inflation-adjusted) interest rates. This is important because commodities are real assets whose prices can be expected, in general, to increase in line with inflation. The upshot is that if the Fed is raising nominal interest rates to counter rising wage and price pressures, the net effect on real interest rates (and on demand for inflation hedges such as gold) could be zero.

Admittedly, this distinction may be too subtle to have much impact on sentiment. However, other factors may come into play too. Perhaps the most important is simply that US official interest rates are unlikely to rise very far.

"Our own forecasts are relatively hawkish, but even we only expect the Fed funds rate to be increased to around 2% in 2016 and 3½% in 2017. This in turn implies only a small change in the opportunity cost of holding commodities and perhaps none at all if offset by an increase in the general level of inflation", says Capital Economics in a research note.

What's more, the impact of even a small increase in real interest rates could easily be trumped by other factors. Indeed, what happens to demand from China is far more important for most commodities than whether US interest rates end next year at zero, or at 2%.

Similarly, the fall-out from the earlier slump in commodity prices is likely to have a much bigger (and negative) impact on supply than any boost from a small increase in potential investment returns for producers and in the costs of carry inventories.

"We continue to expect the ECB, Bank of Japan and People's Bank of China (among others) to loosen policy further. Admittedly, this probably will put some renewed upward pressure on the dollar against other major currencies, but the bulk of the dollar's appreciation is now in the past. What's more, improving sentiment towards the global economy (and China in particular) should support many emerging market currencies.The upshot is that we think the outlook for US interest rates should be seen as just one of a number of factors that will determine the prospects for commodity prices over the coming years, and in most cases it is not even the most important", added Capital Economics.