Commodities tend to move lower when real interest rates rise, as supply increases and capital flows into higher yielding assets. For instance, commodity prices soared in the 1970s as real interest rates moved into negative territory. Commodity prices then fell in the 1980s when Paul Volcker raised interest rates to fight inflation and real interest rates reached all-time highs. There is a very strong inverse relationship between real interest rates and commodity prices over time.
In recent years, both nominal and real interest rates have been very low due to central bank monetary easing policies and low inflation expectations. These dynamics helped commodity prices move substantially higher following the 2008 economic crisis. Of course, the price of individual commodities also depends on a variety of other micro- and macroeconomic factors, including the impact of various market players — such as OPEC — and global growth rates.
In this article, we’ll take a look at where commodity prices may be headed if the Federal Reserve raises interest rates, and we’ll discuss some pockets of opportunity.
Where We Are Now
It’s important to distinguish between nominal and real interest rates, since real interest rates are the only important factor to watch when it comes to correlation with commodity prices.
Nominal interest rates don’t take into account inflation, while real interest rates represent the nominal rate minus expected inflation. If interest rates rise due to increased inflation expectations, the real interest rate remains relatively steady. If nominal rates move higher in the absence of inflation expectations, then real interest rates rise and commodity prices fall as investors seek out higher yielding assets.
In the current economic environment, nominal and real interest rates are both very low, since there’s a low expectation for inflation in the future. The impact of a Federal Reserve rate hike would depend on whether inflation is set to increase or remain low. If inflation remains low, real interest rates would increase and commodities could suffer. If inflation increases, then real interest rates would remain low and commodities could still be attractive.
Finally, investors must consider these dynamics in the context of other micro- and macroeconomic factors influencing commodities. For instance, a growing global economy could boost demand for commodities at a time when supply has been shut down, while supply-demand economics in specific commodities could influence prices. These dynamics could offset any weakness in prices stemming from rising real interest rates in the United States.
Commodities to Consider
Most commodities react in the same way when real interest rates move higher and lower, but some commodities have stronger correlations. For instance, cattle have the strongest historical correlation with real interest rates looking back to the 1950s. The problem with trading or investing in individual commodities is that the impact of real interest rates could be offset by commodity-specific issues that have an even greater influence on prices.
Traders may also want to consider whether or not to invest in commodity producers — such as miners — or physical commodities. In many ways, producers may experience less of an impact from rising real interest rates since they have greater control over production levels and tend to be less volatile than physical commodities. The downside is that these producers also have their own microeconomic factors influencing their prices, such as corporate earnings.
One solution is simply investing in a broad basket of commodities or producers in order to avoid any commodity-specific risks and still capitalize on the broad trends. The iPath Bloomberg Commodity Index ETN (DJP) is a popular option with exposure to a broad basket of commodities. The ETN is 33% weighted in energy, 23% weighted in grains, 17% weighted in industrial metals, and 16% weighted in precious metals.
The Bottom Line
Real interest rates have a well-defined impact on commodity prices. If the Federal Reserve raises nominal interest rates, the impact on commodities will depend on investor expectations for future inflation and the offsetting impact of increased demand from global growth. Investors interested in capitalizing on these dynamics may want to consider broad baskets of commodities or commodity producers rather than specific commodities.