Federal Reserve Chairwoman Janet Yellen indicated that the central bank would “proceed cautiously in adjusting policy” during her remarks at the Economic Club of New York. After raising interest rates by a quarter of a percent in December, the central bank has taken a much more dovish stance and reduced its number of anticipated hikes from four to two. These changes have had a profound impact on the financial market throughout the first quarter.
Below, CommodityHQ.com takes a look at what a dovish policy means for commodities and how investors can best position themselves to benefit.
The Federal Reserve & Commodity Prices
The Federal Reserve’s dovish sentiment has a profound impact on all kinds of financial assets since it influences interest rates. In general, low interest rates tend to put downward pressure on the U.S. dollar as investors transition to higher-yielding currencies. The lower dollar valuation puts upward pressure on dollar-priced commodities since more freshly devalued dollars are required to buy the same amount of a given commodity.
However, the relationship between the Federal Reserve and commodities isn’t a one-way street. Lower commodity prices tend to have a deflationary effect on the economy. After all, lower input costs encourage manufacturers to cut prices to better compete. Consumers often respond by holding off on major purchases in anticipation of lower prices in the future, which causes prices to move even lower in an effort to maintain sales.
Expectations of lower interest rates in today’s market have certainly helped commodities, but as prices begin to rise, it could have an inflationary impact on the real economy. This could help justify future interest rate hikes by the Federal Reserve and ultimately cap commodity gains.
A Look at the Winners & Losers So Far
Most commodities gain in value when interest rates fall and lose value when interest rates rise when everything else is equal. As mentioned earlier, this occurs because more freshly devalued dollars are required to purchase the same amount of a given commodity.
The best-performing commodities during the first quarter have been gold and silver, which have increased 21.66% and 26.46%, respectively (see Figure 1). At the same time, crude oil prices have rebounded from their lows, and metals like copper and palladium have seen modest rallies. Many investors have moved into gold and silver given the lack of high-yielding alternatives and potentially overvalued equity markets threatened by slowing growth.
Natural gas, coffee, orange juice, and cattle have been among the worst performers over the same time frame. These commodities have been largely hit by adverse fundamentals news that has more than offset the beneficial effects of the dollar. For instance, coffee prices have trended downwards throughout the year thanks to robust production in Brazil – although prices have been offset more recently by concerns over mealybug infestations.
Where Are Commodity Prices Headed?
The price of gold and silver will continue to be impacted by perceived changes to monetary policy. Since they have relatively stable supply and demand, these commodities are much more of a “pure play” on inflation than industrial metals, energy, or agricultural commodities. They may also be influenced by technical factors and the economics of exchange-traded fund (ETF) buying and selling, which could introduce volatility to these markets in the future.
Energy commodities, such as crude oil and natural gas, will continue to be driven largely by macroeconomic factors and OPEC’s decision-making. Similarly, agricultural commodities will be affected largely by supply and demand economics in various markets. These dynamics will likely have a much bigger impact on the price of the commodity than interest rates and investors should follow these developments in their analysis.
Those looking for broad exposure may want to consider ETFs like the PowerShares DB Commodity Index Tracking Fund (DBC), which tracks a basket of commodities that are diversified away from acute risks impacting individual markets.
The Bottom Line
The Federal Reserve has a significant impact on commodity prices via its influence on interest rates. In general, commodity prices tend to move higher when interest rates move lower and vice versa. The most affected commodities include precious metals, like gold and silver, while other commodities, like energy and agriculture, are influenced by more external factors.