The Federal Reserve isn’t doing any favors for commodity markets already enduring the longest slump in decades.
By raising U.S. interest rates for the first time since 2006, the central bank has bolstered the value of the dollar, the currency used around the world to buy and sell most raw materials. Even with global surpluses and slowing economies keeping prices low for everything from crude oil to wheat, demand may weaken, especially from major importers in Asia like China and India that have been key drivers of commodity buying.
“The currency movement due to the U.S. rate increase will have a direct impact on our business,” said Kazuo Kagami, the president of Toho Titanium Co., which makes a lightweight, super-strong alloy used in everything from airplane parts to golf clubs. The Chigasaki, Japan-based company sells half its products overseas in dollars.
All sorts of raw materials have global surpluses after heavy investment in new production over the past decade boosted supplies, which began arriving just as demand slowed. The Bloomberg Commodity Index of 22 items plunged 27 percent this year, the biggest drop since the financial crisis in 2008. The gauge is down for a fifth straight year, compounded by a surge in the dollar against almost every major currency during the period.
The Bloomberg Dollar Spot Index rose the most in a month on Thursday and has rallied 9.7 percent this year. The Bloomberg Intelligence Global Large Base Metals Competitive Peer Group index, which tracks 18 mining companies, slid 2.4 percent on Thursday, extending this year’s decline to 51 percent. The 40- company Standard & Poor’s 500 Energy Index fell 2.1 percent, down 24 percent for 2015.
Limiting Demand
While low prices can sustain some demand, it may not be enough. The Fed’s decision to raise borrowing costs by 0.25 percentage point, up from zero percent, marks the beginning of the end for an unprecedented era of easy monetary policy. That may mean sustained strength for the dollar and limited demand for raw-material imports from countries with weaker currencies.
Higher interest rates will boost costs for metals traders who have been benefiting from low borrowing costs. More than 90 percent of the aluminum stored in warehouses around the world are tied up in financial transactions that seek to exploit the gap between current prices and higher ones in the future, a market condition known as contango, according to researcher Harbor Intelligence.
“The financing today is very much dependent on the contango in the market and also the other side, which depends on the warehousing costs and the interest rate,” said Svein Richard Brandtzaeg, the president and chief executive officer of Oslo- based Norsk Hydro ASA, Europe’s largest aluminum producer. “That change in interest rate will have a decisive effect on the margins of these deals of metal inventories.”
While the 0.25 percentage-point increase by the Fed on Wednesday won’t lead to a flood of metal out of storage, new deals would be “unprofitable to finance,” if other elements stay unchanged, said Jorge Vazquez, Harbor’s managing director.
Gold Rebound?
One exception may be gold, which has declined for three straight years. Prices have dropped from a record high in 2011 – – touching a five-year low this month — in part because a rallying dollar eroded investors confidence in the metal as an alternative asset and inflation remained in check.
Now, 17 of 28 traders and analysts surveyed by Bloomberg said the precious metal will rise in 2016, with a median year- end estimate at $1,200 an ounce, 12 percent more than now. In four of the past seven times the Fed began raising rates, gold was higher six months later, according to Credit Suisse Group AG.
“Once the Fed raises rates, the uncertainty is gone, and gold should be able to gain ground,” Daniel Briesemann, an analyst at Commerzbank AG in Frankfurt, said by phone on Monday.
For oil producers in North America, where an output surge over the past decade has helped send crude below $35 a barrel, the lowest since 2008, increased borrowing costs may have little or no impact.
The 34 percent plunge in prices this year already has limited access to financing for energy companies, said Paul Tepsich, a portfolio manager at High Rock Capital Management Inc. in Toronto. “They’re shut out of the market, so its irrelevant what the Fed does,” he said.
Gasoline Demand
The U.S. gasoline market may not be immune. While the lowest pump prices since 2009 and an improving economy helped boost demand to an all-time high, raising interest rates too fast could end up slowing growth and leave motorists with less money to spend on driving, said Carl Larry, head of oil and gas for Frost & Sullivan LP in Houston.
“If an interest-rate hike slows down job growth, it would be a deterrent to increasing gasoline demand,” Larry said.
The news isn’t all bad. The strong dollar has been a boon to some commodity exporters, like farmers in Brazil or miners in Australia, because many of their costs are paid in their domestic currency. While soybean futures have tumbled 16 percent in Chicago this year, they’re up 24 percent when measured in Brazilian reais. A weaker peso in Chile, the world’s largest copper producer, has softened the blow of a 28 percent drop in the price of the metal.
“The one thing that’s saved the miners globally has been the domestic sustaining cost function of their valuations, and the fact that it’s getting cheaper in U.S. dollar terms to maintain production in a South African or Brazilian or Peruvian copper mine,” said George Zivic, a portfolio manager of the Oppenheimer Commodity Strategy Total Return Fund.
But with demand slowing, the prospect of rising supplies of everything from iron ore and oil to wheat and corn suggests commodities priced in dollars may weaken further.
How Long?
The impact of higher interest rates may depend on how long and how fast the Fed makes its moves. After the increase of 25 basis points this month, traders expect a further increase of 75 basis points by the end of 2016, said John Davies, global head of commodities research, at BMI Research.
“If the Fed were to follow a far more aggressive hiking cycle than the market expects, then there could be significant additional downward pressure on commodity prices, particularly precious metals,” Davies said.
