At present, there is a lot of noise about a “commodities bubble.” The majority of “experts” are convinced that commodity prices have risen too much and they’ll collapse. On the other hand, stocks and bonds are being touted as bargains – or as the foolproof road to riches and financial freedom! These days, the mainstream media is awash with analysts who are claiming that commodities will suffer due to rising rates. Frankly, I find their argument totally absurd.
Invest in commodities: correlation with interest rates
History has shown that commodity prices are positively correlated to the direction of interest rates. On the other hand, financial assets such as stocks and bonds are negatively correlated to rates.
During the 1970’s, rates soared and this period coincided with a gigantic bull-market in commodities. Despite sky-high rates, all the commodities went up several-fold! It is interesting to note that the 1970’s saw a vicious bear market in stocks and bonds.
Back then, the United States underwent a huge recession and Britain had to be bailed out by the IMF. rates peaked in the early 1980’s and this coincided with the end of the commodities boom. In the following two decades, both rates and commodities declined whilst stocks and bonds witnessed a huge boom.
There is no doubt that the previous commodities boom took place amidst rising rates and a severe recession. So, next time when the “experts” claim that commodities are about to collapse because of rising rates and a slowing economy, perhaps you can direct them to a good history teacher!
Invest in commodities: the inflation myth
I’ll let you in on a secret, which is essential to your success as an investor. You must understand that the central banks don’t raise interest rates to fight inflation. After all, the modern-day central banking system is inflation! Central banks raise or lower rates in order to manage the public’s inflation fears or expectations. During such times when the public wakes up to the inflation problem and starts losing faith in the world’s paper currencies (present scenario), central banks raise rates to show that they’re fighting inflation. Interest rates are pulled up in an effort to restore confidence in the world’s currencies as a higher yield makes currencies more attractive. On the other hand, when the public’s inflation fears are under control and confidence in the monetary system is high, central banks lower rates to create even more inflation!
During cycles of monetary easing, the rate of inflation (money-supply and credit growth) accelerates, thereby creating an economic boom. During periods of monetary tightening (such as now), the rate of inflation (money- supply and credit growth) slows down temporarily, causing financial accidents in a highly leveraged global economy. Make no mistake though, the response or cure offered by the central banks to every financial accident is always more inflation and credit.
At present, every central bank has assumed the role of an “inflation-fighter!” Rates are being increased in the majority of countries under the pretence of controlling inflation. However, it is worth noting that despite rising rates, our world is still awash in liquidity. Recently, the non-gold foreign exchange reserves held by the central banks rose to a record $4.4 trillion US, up nearly 10% year-on-year! Emerging nations held a record $3.07 trillion. The US and the developed nations held a near-record $1.33 trillion US
Opinion is divided as to whether US interest rates will continue to rise. The majority seems to think that the Federal Reserve won’t raise rates much further for the fear of seriously hurting the housing boom. However, I feel that the US rates will have to continue to rise or else the US dollar may stage a dramatic decline. Given a choice between protecting either the housing boom or an outright collapse in the US dollar, I can assure you that the Federal Reserve will choose the latter. The truth is that the Federal Reserve exports US dollars to the entire world and it’ll do everything in its power to delay the destruction of its merchandise. In summary, I concede that the Federal Reserve may pause during the second half of this year to offer some respite before the US mid-term election in November. However, the major trend is now up and rates may well be in double-digits within five years.
Invest in commodities: set to outperform other asset classes
If my above assessment is correct, you can bet your bottom dollar that US stocks, bonds and property are going to come under serious pressure. Already, the real- estate market in the United States is showing signs of a slowdown as the establishment tries to engineer a soft landing. In my opinion, we now amidst a global housing bubble, which will eventually deflate due to rising borrowing costs. It is interesting to note that the bond yields fell between 1981 and 2003. As the cost of borrowing declined, housing as well as bond prices went through the roof!
However, in June 2003, bond-yields bottomed out and have been rising ever since. Over the past three years, the cost of borrowing has become more expensive and we’re beginning to see its impact on the slowing real-estate markets worldwide. The US 10-year Treasury yield has now broken out of its 20-year downtrend and this is an ominous development. This breakout points to much higher interest rates in the future, so I’d have to advise you to sell your leveraged properties and bonds without further delay. The great bull market in bonds ended in June 2003 and this is not a good time to be invested in fixed-income assets.
In the past, I’ve stated that in a highly inflationary environment, stocks, commodities and real estate can all rise at the same time. Basically, an over-supply of paper money causes its purchasing power to diminish. I still maintain that over the coming decade, even if all assets (with the exception of bonds) continue to rise, I expect commodities to outperform all other asset classes on a relative basis.
By Puru Saxena for The Daily Reckoning. You can read more from Puru and many others at www.dailyreckoning.co.uk
Recommended further reading:
See our section on investing in commodities for a full list of articles, including: Merryn Somerset-Webb on investing in uranium; why Jim Rogers thinks the commodities bull will run until 2022; and how you can profit from the energy crisis.