In the current economic environment, commodity investment has become increasingly popular for many reasons. Simultaneously, the dollar has demonstrated significant weakness against other world currencies, and the roles of the Federal Reserve and U.S. Treasury have been the subject of increased discussion. As central banks worldwide attempt to thread the needle between protecting the housing market and leaving inflation unchecked, experts agree that a degree of price appreciation is inescapable. As such, commodities represent an excellent store of value.
Commodities and a Weak Dollar
During periods when the relative position of the U.S. dollar is under attack, commodities tend to perform well. One of the principal reasons why this is true is that commodities are considered a good place to store wealth. This is tied to the concept of purchasing power. The exchange rate between two currencies represents two factors: how much of each currency is needed to purchase the same model basket of goods, and an implied future-looking view about inflation in the two respective countries. The exchange rate is meant to represent the purchasing power parity – the fair corresponding amount of each currency needed to obtain the same basket.
When the U.S. dollar is weak, this means that it requires more dollars to purchase the same model basket. One way to avoid this depreciation in the value of the dollar is to buy the model basket instead. While there is no actual basket for sale, commodities represent the goods in question. Put in another way, if it takes more dollars to buy the commodity, the commodity’s price has gone up and proven to be a good store of value and a good investment.
Inflation and the Rise of Commodity Investment
In a similar sense to the purchasing power parity between two different currencies, inflation explains the declining purchasing power within a single currency. The same model basket of goods that has a particular dollar value today will cost more dollars in the future as a result of inflation. Inflation expectations, as much as actual inflation, tend to be a precursor to an increase in commodity investment. As was discussed above, commodities tend to be considered an excellent store of value. If you know that the model basket will cost more in the future, buying it today preserves one’s purchasing power. As the value of your dollars decreases, owning raw materials preserves wealth.
Gold Bugs Unite
The last factor that has aided in the measured increase in commodity investing is the economic crisis itself. At times when individuals are uncertain about the future of the economy itself, commodities with intrinsic value are demanded. Gold in particular is considered a safe haven at times of financial turmoil. While the global shuffle may leave many things uncertain, most people assume that gold will always protect value and be in demand as a form of tender. Recent economic events have led gold to recently touch all time highs. As many commodity traders follow and join trends, some of these increases become self-fulfilling prophecies.
Overall, the increase in commodity investment is a function of a weak dollar, inflation concerns, and as a reaction the economic turbulence that rocked the financial system. Commodities can be an extremely lucrative investment if made carefully, but having a sense of when a trend is reversing and knowing how to protect one’s profits, is critical to being successful in this arena.