As I noted recently, the Fed’s third round of quantitative easing is fairly aggressive, but it is unlikely to have a significant impact on the economy – especially if policymakers in Washington lead us over the fiscal cliff. But where QE3 may have an impact is in the commodities market, and in particular gold. Here’s why:

For starters, the Fed’s actions – coupled with similar programs in Europe and Japan – may not change the economic fundamentals, but it could continue to support the “risk-on-trade” (assuming we can avoid the fiscal cliff) that we saw following the announcement. The rally may last longer, even though it is not clear that QE3 will change much. But a “risk on” rally would most likely benefit commodities.

Longer term, however, the Fed’s move could support gold in particular. Historically, the most significant driver of commodity returns has not been the absolute level of inflation or changes in the dollar – the two factors investors typically focus on – but the level of real-interest rates. This has been particularly true for gold, which has, at least historically, been the biggest beneficiary of low real rates.

The argument why this is the case is not hard to understand.  In an environment in which real rates are very high, as in the mid-1980s, there is a huge opportunity cost to holding gold.  Conversely, when real-rates are low or negative as they are today, there is no opportunity cost in the form of foregone interest. Historically, this relationship has been so strong that since 1990 the level of real rates – measured by comparing the Fed Funds rate to core inflation – explains roughly 45% of the variation in gold.

Given the Fed’s recent announcement to extend their guidance on holding the Fed Funds rate between zero and 0.25% until mid-2015, investors have an unusual degree of visibility into future monetary policy. In the absence of a slide into Japanese style deflation –increasingly unlikely with inflation expectations actually rising – real-rates may remain negative for many years.

Subscribe to our free daily newsletters!
Please enter your email address to subscribe to ETF Trends' newsletters featuring latest news and educational events.