Robust economic growth and high inflation will likely lead the Fed to raise interest rates this year, and commodities typically outperform other asset classes during the hiking phase of the interest rate cycle.
Last year was a strong one for the commodity asset class. At the headline level, the Bloomberg Commodity Index gained 27.11%, easily making it one of the top-performing parts of the market. You’d have to go back more than two decades, to the start of the last commodity supercycle, to find a similarly strong calendar-year result.
A lot went right for commodities over the year—consumer demand for goods was strong, in part because of numerous rounds of stimulus doled out by Congress—and rising inflation made for a supportive backdrop. In addition, supply-side impediments for many commodities further squeezed the situation, putting upward pressure on prices.
As we attempt to navigate 2022, we’re faced with a very different landscape from a year ago. Commodity performance has remained strong, with some prices reaching record levels as investors the world over brace for further supply disruptions in the wake of Russia's invasion of Ukraine. Economic uncertainty has risen substantially. But if all goes as the market expects, the Federal Reserve will be well on its way to hiking interest rates by year-end and may no longer be carrying a balance sheet nearly two-fifths the size of the US economy.
Inflation, which has been running at a 30-year high, is expected to moderate as the year rolls on, forecasted by a group of economists polled by Bloomberg to fall to 5.8% on a year-over-year basis by midyear, then 3.3% by December. On the surface, many investors might view this backdrop as unsupportive to commodity performance. Commodities, after all, have been proclaimed to hedge inflation, exactly the thing the Fed is now focused on reining in. In reviewing commodity performance during prior interest rate cycles, however, we find evidence that commodities typically outperform other common asset classes during the rate-hiking phase before moderating after. In addition, we point to the high degree of scarcity pricing across most major commodities as further evidence that prices may need to stay high for some time to help bring additional supply into the market.
Commodity performance during interest rate cycles
In reviewing the prior 35 years of data for the federal funds target rate (midpoint of range), we find five well-defined interest rate cycles. Each begins with the Fed hiking rates, followed by an extended pause before rates are cut and held low for some time. In our analysis we define these periods as hiking, pause high, cutting, and pause low. The following chart compares the annualized average monthly total returns for commodities, stocks, and bonds over these phases.
Common asset-class performance during different phases of the interest rate cycle, annualized average monthly returns, 1987–2021
Sources: Federal Reserve, Bloomberg, MSCI, and Parametric, 1/27/2022. For illustrative purposes only. Past performance is not indicative of future results. It is not possible to invest directly in an index. “Commodities” represents the Bloomberg Commodity Index Total Return, “stocks” represents the MSCI USA Gross Total Return Index, and “bonds” represents the Bloomberg US Aggregate Total Return Index.
On average we find commodities have performed best during the hiking phase of the interest rate cycle, followed by stocks, then bonds. These results shouldn’t come as a surprise, however. Generally, interest rate hikes follow periods of strong growth in the US economy, which are often accompanied by rising inflation. Often these conditions arise during the later stages of the business cycle, when demand for raw materials is quite high, which puts upward pressure on commodity prices.
This resembles the current environment quite strikingly. Real GDP growth has rebounded strongly following the COVID-19 dip, and economic output sits nearly on par with the prepandemic trend. Concurrently, inflation has clearly eclipsed what the Fed is comfortable with, hence the acute focus on the institution’s next move from most market participants.