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Commodities Drag Could Put Federal Reserve in Tough Spot

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September 29, 2015
Commodities Drag Could Put Federal Reserve in Tough Spot

Fresh financial troubles for a commodities mega-producer this week may underscore larger problems for the global economy and for a Federal Reserve that likely could do without commodities volatility distractions. The Fed is looking to return the U.S. to a “normal” interest rate climate but its policy path isn’t as clear as it once was.

Fed Chair Janet Yellen left the door open to an interest rate hike yet this year when she spoke last week (Yellen takes the podium again this week). Her confidence in the global economy’s resiliency cheered the stock market. But that good mood was fleeting, as some analysts wonder if the Fed really can ignore China’s slowdown and its crimp on commodities demand.

Investors, too, aren’t sure about commodities price health as reflected in a 30% drop in shares to start the week for London-listed mining giant Glencore. Its struggles to meet debt-reduction targets and its spinoff plans for some mining units appeared to disappoint investors.

"It doesn't take a rocket scientist to determine that Glencore's earnings prospects have been greatly diminished with the huge drop in commodity prices," says Patrick O'Hare, chief market strategist at Briefing.com.

Glencore and others have shouldered a drop to multi-year lows for several key commodities. This includes oil’s fall below $38 a barrel, the lowest level since February 2009, this summer; it’s trading near $44 a barrel so far this week. Futures prices for copper—widely used in industry and construction and a barometer of global economic health—registered their lowest reading since July 2009 in August at $2.2275 a pound and remain near there. Another big drop came for gold, trading at its lowest since 2010 in late summer before a mild rebound stopped short when Fed Chair Yellen kept that rate hike on the table.

Low Commodities Equal Low Inflation (For Now)

There’s more to the story than immediate stock impact. Commodities could be holding back pricing traction in general. Below-target inflation is one factor hamstringing the Fed's intention to move forward with its first rate hike since before the global financial crisis hit in 2008. The Fed's preferred inflation gauge—the personal consumption expenditure (PCE) index—showed inflation was unchanged in August from a month earlier and up a tepid 0.3% year over year.

Stripping out the volatile food and energy sector, core PCE was up 1.3% year over year, still under the Fed's 2% target.

"Most Street analysts would argue that the price of crude oil is hampering the Fed's desire to hike interest rates," says JJ Kinahan, chief market strategist at TD Ameritrade.

"The [Fed] is looking for a little inflation, but consumer prices are lower than they would like,” he adds. “Crude oil is one of the greatest contributors to inflation and one of the reasons inflation hasn't been able to hit the Fed's 2% target.”

Publicly, Fed officials appear to be downplaying the importance of the drop in crude oil prices.

"The Federal Reserve keeps harping on the idea that it thinks the decline in energy prices is quote 'transitory,’ so it is taking a look at core trends,” says Briefing’s O’Hare. “The Fed and Yellen have said they don't need inflation at 2% to hike rates but that they need to be reasonably confident that it’s moving toward 2%.”

The Oil “Indicator”

The Fed’s own confidence could help underpin commodities prices. In fact, a Bank of America/Merrill Lynch research report this month offered this headline: “No $20 Oil in Sight.” Analysts there, who’ve pegged oil at $50 a barrel by year-end, think the worst of the over-supply concerns are done.

However, O'Hare warns, "If commodity prices continue to come down, a data-dependent Fed is unlikely to raise interest rates before the end of the year."

That leads some analysts—and investors, too—to look for potential Fed signals in the oil market (see figure 1). That includes futures trading and in key market-driving supply and demand reports.

"Before the Fed can raise rates, crude oil will probably have to go higher, as it’s usually a leader of inflation," says Kinahan.  

thinkorswim-oil-chart

FIGURE 1: DRILL DOWN ON OIL.

TD Ameritrade clients can monitor crude oil with the Active Trader Trading Ladder feature, shown here on the new-look thinkorswim® platform from TD Ameritrade. This chart view offers an in-depth look at futures trading activity, including the depth of the book and current trades. To get there, log in to the thinkorswim platform, click Trader, then Active Trader. In the symbol box in the upper-left-hand corner, type contract ticker /CL. For illustrative purposes only. Past performance does not guarantee future results.

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