Expectations for a Federal Reserve hike
While growth is disappointing, it’s arguably still strong enough to justify an initial Fed hike later this fall. Expectations for tighter monetary policy are impacting commodities in a few related ways. Central bank divergence, i.e. the Fed hiking while most other central banks are easing, is likely to push the dollar, already up 8 percent year-to-date, higher. In addition, certain commodities, notably precious metals, are being negatively impacted by rising real rates.
Market Realist: Precious metals could decline further as the dollar strengthens and real rates rise.
There’s a strong inverse relationship between the US dollar (UUP) and commodity prices. The main reason why this happens is that commodities are priced in dollars. When the value of the dollar increases, it takes fewer dollars to buy commodities, and vice versa.
The divergence in major central bank policies is one of the main reasons why the dollar has appreciated, as the graph above shows. The dollar index that gauges the value of the US dollar against a basket of major currencies has gained nearly 30% over the last 12 months.
While Japan and Europe are seeing excess liquidity in the form of quantitative easing, interest rates are likely to rise in the United States. Remember, funds flow to the country with higher interest rates in the short term, making its currency stronger. With the divergence likely to last for a while, the dollar could strengthen further, which would be negative for commodities (DBC).
Precious metals such as gold (GLD) (IAU) underperform when real interest rates rise, as the graph here shows. The real interest rate is the difference between nominal interest rates and inflation. We’ve used the ten-year US Treasury (IEF) as a proxy for nominal interest rates.
As you can see, real rates started rising in mid-2011. Since then, gold has lost one-third of its value. With inflation still absent and nominal interest rates likely to rise, gold prices are likely to fall.