What Is The Relationship Between Interest Rates and Commodities’ Prices?

At a glance:

• We look into what commodities’ trading is and analyse closely the relationship between commodities’ prices and interest rates.

• We also look at the reason behind the nature of this relationship and also look at which other factors may affect fluctuation in prices of commodities.

Introduction to Commodities’ Trading

Trading commodities has always been an essential part of human life since the beginnings of civilisation. It can even be argued that the strength of an empire was assessed on its ability to manage complex trading systems and ease the exchange of commodities between citizens.

Jump forward to 2019, the trading of commodities still makes up a sizeable chunk of the market.  Tradable commodities fall into four categories: metals, energy, livestock and meat and agricultural.

Traders tend to overlook the importance of interest rates when trading in the commodity market. They tend to focus on short-term supply or long-term trends in major international markets.

However, there is a very strong relationship between the prices of commodities and interest rates which all traders should look into before they start trading commodities.

Interest rates and the prices of commodities — how do they relate?

Historically, there has always been an inverse relationship between interest rates and prices of commodities. Whenever interest rates soar, the prices of commodities drop and vice versa.

The cost of carry, the costs associated with holding inventory, is the main reason why there is such a close relationship between the interest rates and raw material prices.

This is why it is so important to keep interest rates in mind while assessing the future prices of commodities.

So, why are commodity prices impacted by interest rates?

There are three main reasons why interest rates impact commodities prices so strongly.

Given most commodities are storable, the owner needs to decide where and how the material will be stored. His/her decision will depend on price expectations, storage costs, and risks.

The higher the interest rate the more likely the commodity will be extracted. This results in a non-interest earning that ends up liquidated shortly after to profit through the sale.

As mentioned previously, the carrying costs of inventories is a major reason behind fluctuating interest rates. When the interest rate rises, investors try to lower the inventories which automatically lower the demand.

The third reason is the financial speculation in commodity markets. When hedging, many traders include commodities as part of their trading portfolio and so when interest rates drop, traders tend to look for other assets to invest in such as stocks or bonds. This then leads to a destabilisation of prices.

What other variables may impact the prices of commodities?

Economists have listed several factors that impact commodity prices. Scarcity results when there is an excess of demand for a limited amount of raw material. This, in turn, leads to the rise in the prices of commodities.

The Fed may choose to raise the Federal Funds Rate as happened on the 21^st March 2018 whereby the rate was raised by 25 basis points. This increase in rates usually occurs when the Fed is trying to control runaway inflation or to influence a red-hot economy.

Another factor that may impact the price of the commodity is the velocity of money. In simple terms, this is how long people hold onto their money. Generally, in times of high inflation, people want to spend money as quickly as possible before it loses its value.

This, in turn, will influence the economy and so the price of commodities fluctuates.

You can Trade Commodities with OspreyFX

OspreyFX offers a variety of assets to trade such as metals and energies with several pairs such as silver against US Dollar, Gold against Euro and Palladium against US Dollar.

Learn more about the commodities pairs we offer here.