When I started in this business I was immediately intrigued by the concept of interest rates. I read anything I could find on the subject and since then I have been totally fascinated by their behavior.

One of my major conclusions, as naïve as it may sound, is that interest rates represent the price of money. As soon as you accept this idea, you have to believe money is a commodity. As such it is driven by the markets. Forget about the Fed and what the press writes about the subject. More details in the following pages.

The next step for me was to check this proposition. If money is a commodity, I thought, its price should be closely related to the price of other commodities. The graphs I prepared told me, without any doubt, my idea was correct.

All the major cyclical turning points of commodities and short-term interest rates coincide in an amazing way. This finding made me conclude the price of money and commodities is driven by the same forces. Certainly not the Fed. How could that be? Can the Fed control short-term interest rates and commodities?

I was therefore surprised when a recent column in the Financial Times discussed a paper by two professors from the University of Pennsylvania and Yale suggesting, among other things, commodities offer a good way to hedge the volatility of the market. You know I have constantly reminded you that rising short-term interest rates should be used as a measure of risk for equities. The higher they go, the higher the risk.

Because of the link between short-term interest rates and commodities, you can also say: the higher commodities go, the higher is the risk for the overall market.

Both markets, the market for money and the market for commodities, are driven by the growth of the economy. They might be temporarily affected by the Fed, thus creating new investment opportunities.

A strong economy is invariably followed by higher commodities and higher short-term interest rates. This is the time to increase your investments in commodity sensitive stocks. Shift to interest rate sensitive stocks when commodities and short-term interest rates decline.

(This Observations appeared in the 10-09-2006 issue of The Peter Dag Portfolio ).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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