Interest Rates and Commodity Prices

It's been a while since we talked about oil, but with prices back up the debates must begin anew.  The aforementioned James Hamilton links to some interesting stuff from Jeffrey Frankel, an economist at Harvard University.  Frankel explores the link between interest rates and commodity prices, and notes an inverse effect.  Here's his explanation:

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels: · by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, forests logged, or livestock herds   culled) · by decreasing firms' desire to carry inventories (think of oil inventories held in tanks) · by encouraging speculators to shift out of   commodity contracts (spot and forward), and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened during 2001-2004. As the Fed funds rate goes back up over the coming year, one can expect commodity prices eventually to come back down. Call it part of the unwinding of the "carry trade."

You can read a fuller analysis on his website, as well as responses to some objections.

The chart on the right plots commodity prices against real interest rates between 1950-2003.  Although there is some correlations, it's clearly not tight.  If the theory is true, or does hold some water, it speaks to one of the few truisms of economics--price controls don't work; even when it comes to the price of money.  Try to hold money artificially cheap, to spur expansion or provide liquidity or whatnot, and the price of raw materials will rise to balance it out.

As elegant as his explanation is, it doesn't fully satisfy the China and India are the cause of everything-crowd.  Their rapidly growing thirst for oil, and the dwindling supply of the easy sweet stuff seems to be a real phenomenon.  It'll be interesting to see what happens over the next few months as we near a peak of the rate increases.

Comments

[Shalom Hamou]

The Yield Curve and the Mineral Bubble

The Hidden Parameter in Interest Rates

Executive summary:

There is a strong link between the evolution of the market price of minerals and the shape of the yield curve.

The idea is that given the shape of the yield curve the marginal cost of extraction of minerals becomes irrelevant to their market price as miners stop maximizing their output under constraint of the marginal cost of extraction.

Profit maximization would have them trying to retain their minerals rather than extract them.

The Hidden Parameter:

The price of minerals has grown unabated since the Federal Reserve has started increasing short term rates above 2.5%.

All of the minerals have grown together, which cannot be explained by the growth of the marginal price of extraction alone: no price increases have caused the price of any mineral to stop its growth as a result of an increased investment in exploration.

This correlated increase in the price of minerals must be caused by a global parameter.

Harvard Economics Professor Jeffrey Frankel made the hypothesis that a decrease in real interest rates ("real" rates exclude inflation) increases the demand for storable commodities.

However during the increase of short term rates from 1% under the chairmanship of Alan Greenspan, inflation didn’t grow as fast as short term rates still minerals kept growing.

Moreover any storage outside the ground would not be economically viable as the cost of storage would be added to the interest rates.

Under this assumption the only storable commodity would be minerals.

My hypothesis is different:

Financial decisions are about choices: if you consider the minerals as short term assets, you come to the conclusion that miners, confronted with an inverted yield curve would, as a group, prefer to hoard their minerals in the ground where storage cost is almost free rather than sell them and invest the proceeds in long term assets.

How else would we understand that the cost of oil was multiplied by 5 over such a short period with a low depletion of the proven reserves?

How else would we understand that all the minerals saw their cost rising at the same period with a next to perfect correlation?

How else would you explain the fact that the rise of minerals started shortly after the rise from 2.5% of short term interest rates by the Federal Reserve?

At the same time the yield curve was under the influence of the famous Greenspan Conundrum, which caused the inversion of the yield curve.

Should the yield curve on the U.S. dollar return to normal, as it did on Monday, the miners would stop hoarding their reserves in the ground and the prices should go down in the direction of their marginal cost of extraction.

That price must be much lower than the expectation of all market participants.

Because the hedge funds holding, outside the ground, are not constrained by the marginal cost of extraction, should the price of mineral go down, we should see some overshooting, in particular with minerals with low industrial use: gold and silver.

The correlation between the shape of the yield curve and the price of commodities is only one of the many overlooked signals that are embedded in the yield curve.

Among others, it can give a precise timing of a possible systemic collapse through a Keynes' Liquidity Trap.

My model of the yield curve never gave a signal of a systemic collapse during the recent credit crisis: it has always forecasted that the Federal Reserve had sufficient room to rescue the market and the economy.

Shalom Hamou
Independant Yield Curve Special Advisor
shalem.ashalem@gmail.com

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