Commodity prices are falling. Fast. But why are commodity prices falling if they’re already at five year lows?
It’s not unusual to see seasonal downswings in commodity prices during the summer months, but the magnitude of this past week’s move is so broad that it’s not seasonal but macroeconomic factors leading the charge.
The movement clearly illustrates the relationship between the dollar, interest rates, and commodity prices. Interest rates are increasing. Dollar is strengthening. Commodity prices are dropping.
The theory behind the movement is that when the Fed “prints money,” the money flows into commodities and pushes prices up – and alternatively prices fall when money becomes scarce. But what, exactly, is the mechanism that causes this relationship to exist?
Increasing interest rates decreases the price of commodities in four ways:
- It increases the pace at which commodities are produced by increasing the incentive for extraction today rather than tomorrow.
- It decreases the producer’s desire to carry inventories. Storage costs increase.
- Institutional investors shift investment out of commodities (high risk) and into treasury bills (low risk).
- Strengthens the domestic currency, which, in effect, reduces the cost of globally traded commodities.
Right now, monetary tightening is widely anticipated in the US, with the FOMC signaling that they will likely raise short-term interest rates sometime this year – most likely September. It’s not seasonality or an actual change, but the expectation of a rate increase that’s pushing commodity prices lower.