Investing in Commodities: A Hedge Against Rising Interest Rates

The Wall Street Journal says its time to load up on commodities. The price charts seem to agree.

“Portfolios that add commodities after the Federal Reserve tightens the discount rate, perform better than portfolios that don’t,” observes Journal writer, Carolyn Cui.

The Fed raised the discount rate in February and seems likely to continue raising rates. Therefore, says Cui, investors should be increasing their commodity exposure. She bases her observation on a new study to be published in the Journal of Investing. The authors of the study researched data from December 1970 through August 2007.

Cui explains the process: “The researchers 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.”

Interestingly, most commodity prices bottomed out in mid-February, which is exactly when the Federal Reserve hiked the discount rate to 0.75% – the first increase in the discount rate in more than three and a half years. From its February lows to the present, the CRB Index of commodity prices is up 8%. The CRB’s advance is not just an “oil thing.” Most commodities are advancing, including the long-slumbering agriculture complex.

Several price indices are validating these recent inflationary signals coming from the commodity markets. The Producer Price Index is up 6% year over year; import prices are up 11.4%, and the ISM’s Prices Paid Index has more than doubled during the last 12 months.

Perhaps these price trends are inspiring the Fed to begin “tightening” – i.e. raising interest rates. Whatever the Fed’s exact motive, it has begun to raise rates…and that’s enough of a reason to begin buying commodities, according to the study Cui cites.

“The strategy is pretty simple to follow and doesn’t require much trading,” says Cui. “During the 37 years the study covered, the Fed changed the discount rate 113 times, but only 18 of those moves represented directional changes – meaning investors would need to get in and out of commodities only 18 times.

“So how can investors take advantage of the latest Fed rate-tightening cycle?” Cui asks. “First, they must decide how much money they want to devote to commodities. The study modeled allocations of 5%, 10% and 15%, and found that the 15% dose produced the best results.

“Next,” she says, “investors need to decide what to buy… There are commodity mutual funds and exchange-traded funds like the iShares S&P GSCI Commodity Indexed Trust. Investors also can make more-targeted bets with single-commodity funds: The SPDR Gold Shares tracks gold prices by holding physical bullion; US Commodity Funds LLC runs a suite of ETFs tracking prices of crude oil, natural gas and gasoline.”

A basket of commodities is probably the best approach for the long-term investor.

Eric Fry
for The Daily Reckoning

The Daily Reckoning