LONDON, March 26: Rising interest rates spell no immediate threat to commodity markets, but they may eventually create a drag on the raging bull rally currently in full swing, analysts said. Commodities have historically gone up as interest rates start to rise as this indicates accelerating economic growth and thus strong demand. But as the tightening cycle kicks in and cools the economy, prices of raw materials should then drop. This relationship may have been distorted by massive inflows of investor money into commodity markets, though the amount is still very small fry compared with other global assets. What is interesting in this cycle is that price rises in commodities were occurring before the Fed raised rates. A lot of speculators were front-running the tightening, Michael Lewis, head of commodities research at Deutsche Bank, said.

Some three years ago, the low interest rate environment fuelled an investment boom in high risk/high yield assets from commodities to real estate or even junk bonds.

The reason why (commodities) are so popular is because they offer higher returns at a time when traditional assets like equities and bonds have been so poor, said John Kemp, economist with Sempra Metals.

Even traditionally cautious pension funds, who only take long positions and dig in for the long term, have shifted money into commodities.

The weaker US currency has made dollar-denominated commodities very attractive for holders of other currencies.

The US Federal Reserve on Tuesday raised its target rate for overnight loans between banks to 2.75 per cent — its seventh consecutive quarter-point increase since June.

But it also hinted it may step up the pace of interest rate rises to counter inflation, causing a rally in the dollar and blowing the froth off many commodity markets.

Gold has lost just over three per cent and copper around one per cent since before the announcement. Losses in cocoa have been more severe with prices sliding 12 per cent in just three days.

END GAME?: Opinions are extremely polarised as to whether the commodities rally will now start to cool. Inflation is rising because of higher raw materials prices.

Therefore, if it is commodities which are the inflationary problem, they have to be part of the solution and the prices will have to come down, said Kemp.

He says this cycle of tightening interest rates will spell the end of a three-year rally that has seen prices for most raw materials double or triple.

You’ll start to see better returns on core assets: an improvement in price/earnings ratios that will make equities more attractive and in bonds, the back end of the curve is coming up, he said, referring to the recent rise in yields on long-dated US treasuries.

But Alan Williamson, metals analyst with HSBC Bank, notes that this time round rates are much, much lower.

The slight problem this time round is that interest rates are coming off a very low level so they may not have much of a dampening impact on demand, he said.

Deutsche’s Lewis thinks the dollar will weaken further next year, but that a tightening in global liquidity conditions would cast some shadows on the commodities rally.

There will be corrections and there is more risk this year than last, when it was almost a no-brainer and you couldn’t really find anything that was bearish, he said.

And speculators, although a powerful and growing force in markets, are not the only part of the equation. Many commodities are underpinned by strong worldwide demand and chronic underinvestment in production capacity.

GOLD: Analysts said gold was so far mostly immune from the direct effects of higher interest rates, but could be under threat as the tightening cycle progressed.

The thing that will begin to break the tight relationship between gold and the dollar will be higher interest rates, but that’s not happening yet, said John Reade, precious metals strategist with UBS Investment Bank.

Most analysts felt that gold would only come under fire when real interest rates (nominal rates adjusted for inflation), which are currently flat to bordering positive, hit four per cent. —Reuters