No aid for slumping commodities as Fed rate hike bolsters US dollar

A pump jack is seen at sunrise near Bakersfield, California, in this Oct 14, 2014 file photo.
A pump jack is seen at sunrise near Bakersfield, California, in this Oct 14, 2014 file photo.PHOTO: REUTERS

HOUSTON (BLOOMBERG) - The Federal Reserve isn't doing any favors for commodity markets already enduring the longest slump in decades.

By raising US interest rates for the first time since 2006, the central bank has bolstered the value of the US 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 US 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 Japan-based company sells half its products overseas in US 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 has plunged 26 per cent this year, the biggest drop since the financial crisis in 2008. The gauge is down for a third straight year, compounded by a surge in the dollar against almost every major currency during the period.

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 per cent, 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 that have been benefiting from low borrowing costs. More than 90 per cent 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.

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 US$1,200 an ounce, 12 per cent 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 SA.

"Once the Fed raises rates, the uncertainty is gone, and gold should be able to gain ground," said Daniel Briesemann, an analyst at Commerzbank in Frankfurt.

For oil producers in North America, where an output surge over the past decade has helped send crude below US$35 a barrel, the lowest since 2008, increased borrowing costs may have little or no impact.

The 33 per cent 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 in Toronto. "They're shut out of the market, so its irrelevant what the Fed does," he said.

The US 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 15 per cent in Chicago this year, they're up 25 per cent when measured in Brazilian reais. A weaker peso in Chile, the world's largest copper producer, has softened the blow of a 27 per cent 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 US 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.

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," Mr Davies said.