• Commodities have been hammered by nearly 45% as the dollar has strongly rallied.
  • The Federal Reserve is poised to increase the discount rate – an action which has historically driven the dollar weaker.
  • Commodities and the dollar are inversely correlated – as the dollar falls, commodities will probably rise.

In case you’re just waking up, commodities (NYSEARCA:GSG) are in the midst of one of the largest selloffs in several years. On a year-over-year basis, those even moderately exposed to the Goldman Sachs Commodity Index (a leading commodity index) have been heavily impacted by the commodity drop of nearly 45%. However, if you are an individual who likes profit (and who doesn’t?), you’re in luck.

You see, the Federal Reserve is moving in on a decision regarding the discount rate. The discount rate is the bedrock rate of the United States economy. Nearly every other interest rate is evaluated as a differential to the discount rate. So when the discount rate increases, ramifications are experienced across the economy.

When businesses make decisions as to how best to allocate capital, they tend to examine opportunities in light of alternative rates of return. Why pursue a project that will offer an uncertain 5% rate of return across 10 years when a less risky alternative offers comparable or better returns? These are the questions capital allocators must ask on an ongoing basis. When the discount rate increases, this hurdle rate of investment by which projects are evaluated increases as well. As the hurdle rate for investments increases, companies slowly begin to cut back spending and pursue fewer projects. This ultimately leads to a slowing business environment and a decrease in the strength of the dollar since there will be diminished demand for dollar-based projects. As you can see in the chart below, there is a clear relationship between increases in the discount rate and the dollar.

For the past 42 years, every time the Federal Reserve has increased the discount rate following period of low, stable rates, the dollar has declined by an average of 10-12% over the next 2 years. In other words, economic theory is substantiated by reality. This gives a powerful investment edge for those who are aware of the instruments that are directly impacted by dollar strength.

Here’s where commodities enter the picture. I’ve heard it said that a picture is worth a thousand words, so take a gander at this.

This almost needs no explanation. As you can see, there is a direct inverse relationship between the strength of the dollar and commodities. As the dollar increases, commodities tend to fall. Conversely, when the dollar falls, commodities rise. The economic theory underpinning this observation is that since the commodities are priced in dollars, when the dollar weakens it will take a greater quantity of dollars to purchase the same amount of commodity. This is simple, straightforward, and provides a powerful investment edge.

As the Federal Reserve increases interest rates, the dollar will probably fall. When the dollar falls, commodities will probably rise. It’s time to buy commodities.