On Rising Interest Rates And Commodities

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The WSJ featured and article titled “Rising Interest Rates Might Be a Buy Signal for Commodities:”

The Federal Reserve raised a key interest rate in February, and market gauges are pointing to more increases in coming months. Does that mean it is a good time to buy commodities?

According to new research, the answer is yes. In fact, periods of rising rates may be the best time to buy.

A study to be published this fall in the Journal of Investing suggests that portfolios that add commodities after the Federal Reserve tightens the discount rate, which is the rate it charges on loans to member banks, perform better than portfolios that don’t—and lower their risk. Conversely, when the Fed cuts the rate, commodity-flavored portfolios suffer more than those without commodities.

The authors, Mitchell Conover of the University of Richmond, Gerald Jensen of Northern Illinois University, Robert Johnson of the CFA Institute and Jeffrey Mercer of Texas Tech University, studied data from December 1970 through August 2007. They added a basket of commodity futures tracking the S&P; GSCI Commodity Index to five types of stock portfolios: value, small-cap, momentum, growth and large-cap.

The commodities added to the returns of all five equity styles during periods when the Fed tightens the discount rate. A 10% dose of commodities would have boosted a small-cap portfolio by the most: 1.67% per year during the restrictive period. That helping of commodities would have added 1% to the momentum portfolio, the least among the five.

Adding commodities also significantly decreased portfolio risk, according to the study. “Commodities, over time, perform much better in a rising interest-rate environment,” Mr. Johnson says.

That is because commodities are generally perceived as an inflation hedge. When the central bank raises rates, it is usually to tamp down inflation, though the Fed said its move in February was designed to reduce the banking sector’s dependence on government credit in the wake of the financial crisis.

While it’s still too early to tell as to when the Fed will raise interest rates further, and when inflation actually will kick in, let’s take a look and see how the Commodity Index (DBC) has fared during the past year:

As you can see, it’s been a sideways pattern with not much upward momentum. My view is that it is way too early to worry about the impact of potential inflation at this point while we are still mired deeply in a deflationary scenario.

Let any inflationary tendencies become more obvious before making alternate investment decisions. At that time, it will be much easier to spot trend reversals in sectors that will benefit from higher interest rates—maybe DBC will be one of them.

Disclosure: No holdings in the above featured funds.

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