It's no coincidence that commodities are rallying after the Federal Reserve delayed an interest rate hike, according to a fascinating research report from Deutsche Bank. Janet Yellen and the Fed are driving global investment returns across all spectrums and for Canadian investors, the implications reach into every corner of their portfolios. Unfortunately, the commodity rally may be short-lived as the Fed's pause is also a sign of deteriorating global growth.
The U.S.-based fixed-income team at Deutsche Bank AG, believes that the connection between the Fed and resources prices goes far beyond "commodities are priced in U.S. dollars." (When the dollar strengthens, commodities, priced in greenbacks, become more expensive in non-dollar currencies, so global resource demand and prices decline.) The end of the Fed's quantitative-easing program, combined with warnings of interest-rate hikes, resulted in a tightening of U.S. money supply growth, a stronger greenback and the beginning of equity market and commodity price volatility.
Within this framework, the Fed's recent decision not to raise rates is responsible for the current commodity rally that extends from oil, to copper and even grains. Global investors had been concerned about a September rate hike, which would have pushed the dollar higher and commodity prices lower. When it didn't happen, a relief rally saw resources prices climb.
The Deutsche Bank analysts are concerned however, that a steadily rising U.S. dollar is inevitable despite the delay in raising rates, "in the beggar-thy-neighbour world of deficient inflation, even if the Fed's tightening expectations are scaled back, it may not be sufficient to shift the dollar trajectory as other countries potentially 'respond' with more easing." So any Federal Reserve efforts to slow or halt dollar strength will be met by global central bank actions to devalue their currencies, which drives the dollar higher anyway.
The big risk is that slow U.S. economic growth will make raising rates impossible. "The Fed's role … is to generate enough inflation for [countries to devalue their currencies to spur exports]. If they don't, then we'll be sucked down along with the rest. The idea that the U.S. economy is a beacon of strength, independent of the rest of the world, is very dangerous and only true if we can actually generate inflation. Since that does not yet appear to be the case, the real risk is that global risk-asset prices are fundamentally unstable."
Declining Fed monetary stimulus and the strengthening U.S. dollar is not just a hurdle for commodity price appreciation, but an indicator of extreme stress in the global economy and markets, in Deutsche Bank's view. It is a sign of economic desperation for emerging markets as investment assets flee to safer U.S. havens.
Much depends on an acceleration in U.S. growth. For months, the U.S. economy was expected to grab the torch of global economic leadership and offset the slowdown in China and elsewhere. But the stronger currency is limiting profit growth for megacap exporters; companies such as Caterpillar Inc. and Hewlett-Packard Co. are laying off large numbers of employees.
The recent disappointing jobs report provided another sign of weakening growth. Further declines in the U.S. economy, both caused and signalled by the stronger greenback, would remove one of the few remaining drivers of global growth. The recent commodity gains would be short-lived in this event, and risk assets and equity markets globally would be further threatened.
Follow Scott Barlow on Twitter @SBarlow_ROB.