"Falling Interest Rates Explain Rising Commodity Prices"

Jeff Frankel has a good set of posts on commodities, both appearing on his blog and on Brad Setser’s (as guest blogger entries). We are featuring them together here. The first section (which was a separate post) argues that “world growth no longer explains soaring commodity prices“; the second argues that interest rates are now the major culprit.

Frankel does the useful service of trying to parse out supply/demand fundamentals from monetary/interest rate factors in the rise of commodity prices. He believes loose money (specifically, low real interest rates) is the big culprit. This will no doubt offend some readers (and also runs againt the argument of Marc Faber, that inflation-adjusted, commodities were exceptionally cheap in 2001 by very long historical measures). But Frankel’s analysis seems reasonable (and his view is shared by James Hamilton).

There are certainly bases for critiquing Frankel’s thesis. Supply issues in Nigeria in particular have elevated oil prices. Bad harvests and a fungal disease have fed the parabolic rise of wheat prices.

But consider Frankel’s fundamental observation: all commodities have moved up, more or less in parallel. And except for grains, they aren’t ready substitutes for each other. You can’t convert a coal fired electrical plant to gas. You can’t run a regular car on diesel fuel. Substitution takes time and investment. Readers also argue that energy costs affect agricultural prices, but I haven’t seen the impact quantified. The most persuasive argument that I have seen for a group of commodities moving together is agricultural products, where harvests have been faltering as demand is accelerating. The sharp rise in the cost of fertilizer due to diminishing phosphorus supplies (and that is a long-term trend) and the shift in emerging economies towards greater meat consumption.

From Frankel:
….we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms. Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

There could well be merit to many of the explanations that have been offered for the rise in the price of oil; one is the “peak oil hypothesis,” and another is geopolitical uncertainty in Russia, Nigeria, Venezuela and – above all – the Gulf. Corn prices have been impacted by American subsidies for biofuel. And other special microeconomic factors are relevant in other specific sectors. But it cannot be a coincidence that mineral and agricultural prices have risen virtually across the board. Some macroeconomic explanation is called for.

The popular explanation since 2004 has been rapid growth in the world economy. The strongest growth has of course been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based – including up to last year the United States and even a reinvigorated Europe. So growth has pushed up demand for farm products, energy and other industrial inputs, right?

This reigning explanation now looks suspect. Since last summer the US economy has slowed down noticeably, and is probably entering a recession. Despite talk of decoupling, it is clear that other countries are also slowing down at least to some extent. In its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1% (from 5.2 % in July 2007, just before the sub-prime mortgage crisis hit, to 4.1 % as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period! (Up some 25% or more since August 2007, by a number of indices. So much for the growth explanation.

If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices.

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, gold mined, 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 spot commodity contracts, 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 in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch’s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.

There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically (see graph below).

But the events since August 2007 provide a further data point. As economic growth has slowed sharply, both in the US and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

Another cautionary note comes from “Lessons from past commodity bubbles” in the Financial Times:

The massive divergence that is occuring currently between rising commodity prices and fading global growth momentum has led to many investors to question if there have been similar episodes in the past.

“Yes,” says Andrew Garthwaite, chief global equity strategist at Credit Suisse, but only twice in the past 38 years, during the summers of 1974 and 1980.

“Both episodes were periods of US recession that happened to coincide with major supply shocks and/or sharp increases in investment and speculative demand for commodities,” says Mr Garthwaite.

Global commodity markets are very tight but there has been no sudden supply shock similar to 1973/74 or 1979/80, according to Credit Suisse. Instead, the investment bank says the primary driver of surging prices today seems to be financial buying by pensions funds, hedge funds and investment banks’ proprietary trading desks.

Mr Garthwaite acknowledges that there are crucial differences between the situation today and the two previous episodes but he says there is a relevant message from history.

“Sharply rising commodity prices may at first trigger or exacerbate a growth downturn, but eventually weak growth gets its revenge, as falling real demand triggers speculative liquidation.”

And Mr Garthwaite warns: “It is one thing to put money into commodity markets, quite another to try and take it out again.”

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  1. vlade

    How about “speculative bubble”? when a lot of freely-sloshing money looks for a home, giving up on the previous bubbles of .com or real-estate (which, of course, has also hard fundamentals in that there’s only limited amount of habitable space on the planet, innit?), commodities might be just the latest tent they found (that is not to say that the upward trend isn’t there, but the generic upward trend is in all assets in the raising population scenario)

  2. Yves Smith

    The rise last year may be warranted (may, I am not at all certain of the fundamentals (opinion among supposed experts is divided on many commodities) and not deep enough into the art to know which contracts are more easily gamed but the action since the beginning of the year looks pretty frothy. Today in line at a store I heard a guy who looked to be blue collar talking about commodities. Another sign of speculative excess.

    We have had deleveraging everywhere. But the last leverage game in town is commodities, since they are exchange traded. So a speculator (say retail or hedge funds with very broad mandates) could use little to no bank borrowings and still be highly geared just by putting down not much more than the contract minimum margin. And you get the interest on your T-bills too.

    BTW, historically, 70% of the retail customers who trade futures win up losing money. I include myself in that statistic, a lesson learned many years ago.

  3. Anonymous

    Yves, Your right. Lower interest rates encourage the leveraging game (the carry trade) and the price signal (even though it is objectively indistiguishable from noise) from the market is that commodities are the palce to make money in this trade.

  4. Anonymous

    I don’t know why this is controversial. When returns on money are negative it is rational for people not to swap their goods for it.

  5. Anonymous

    I agree with you, anonymous at 8:11 AM. I too don’t know why this is controversial.

    What I do believe is controversial is what the true “real interest rate” might be.

    John Williams over at Shadowstats.com makes the argument that, if the federal government had not changed the methodology by which the CPI is calculated, inflation would now be running at 12%, instead of the 4% the that is being reported.

    I think there is also the speculation that there is no limit what the current administration will do to bail out investment banks that have engaged in highly speculative and highly leveraged investment activities, even if the consequence is inflation.

    So there is not only belief that inflation is much greater than what the government is trying to make the American people believe, but the fed is actively courting even more inflation in the future.

  6. Anonymous

    Many people claim the rise in commodity prices are due to the growth in China and the other emerging markets and has very little to do with negative real rates in the US.

    But lets look at this another way:

    What is causing the stellar growth in China? Massive money growth.

    What is causing massive money growth in China? The Dollar peg.

    Why the Dollar peg? Because private investors don’t want to own Dollars when real rates are negative.

    So its the same thing.

  7. Anonymous

    Commodity prices have not all moved up at the same rate.

    Go to stockcharts.com and run a chart of $GOLD:$WTIC, or go look at the chart here: http://www.321energy.com/editorials/mckenziebrown/mckenziebrown031108.html .

    If you have access to charts comparing prices of various grains to oil, that would be useful to look at too. Or, you can run a chart of DBA:$WTIC.

    What you will see is that the gold:oil ratio has been declining since oil production plateaued in spring of 2004–in other words, oil prices have been rising faster than gold prices. Oil prices have also been rising faster than ag prices.

    The trend is clear despite a year of flat oil prices that began in August of 2006, and was caused by the Goldman Sachs reweighting of the GSCI. That forced disinvestment in gasoline longs, and was a brilliant short-term way to rig gasoline and oil prices before the 2006 elections. We’re still not back to the same level of specs in gasoline, although we’re getting closer.

    The trend will be even clearer in another year or two.

    So, it’s not correct that lower interest rates have raised commodity prices at the same rate, as you would expect to see if lower interest rates were the driver of rising commodity prices.

    I could write a 30-page post on this subject, but obviously there’s not enough space here for it.

    The belief in a commodity “bubble” due to Fed policy has become the conventional wisdom. That’s a shame, because it will keep people from smart hedges for their futures.

    Yves, you don’t have to trade commodities to hedge–buy some shares in something stable, like a good royalty trust. (Be sure to read the annual reports of any trust you’re considering, and choose something with a low production decline rate–like 3%). Your share price and dividends go up with the price of oil and/or natural gas, and you don’t have the headaches of trading.

    Or try options on oil futures: http://www.energyinvestmentstrategies.com/2007/12/04/eis-newsletter-8-december-2007/

    Moe Gamble

  8. Anonymous

    well, hello, commodities rise when real interest rates fall? Well, DOH! Dude – what a startling academic insight – and , hey, queen victoria`s dead too! we have been pointing this truism out to people since we started investing in them 4-5 yrs ago and the market clearly clued into this when the current (late?) rally started the day the Fed first cut hte dicount rate back in august…. really, we expect more of this blog!


  9. Anonymous

    I would argue that psychology is as important as interest rates. Given the current economic climate, commodities seem like a good place to invest money. At some point, the bubble will burst, and investors will switch back to currency or something similar.


  10. Anonymous

    Given the popularity of models comparing interest rate levels with equity prices, I guess real interest rate levels are a refinement of the analysis. And there is clearly a positive relationship
    To this I’d add issues like minimal investment to natural resource supply since the last natural resource boom/bust. Also, examine the behavior of the gold companies since then. (Better to sell forward than spot.) But something’s changed; gold companies are now selling spot rather than forward.
    Then let’s look at the weather. Sure hasn’t been good for grains in the past year or so. Just in time inventories; aren’t stockpiles at decades’ low levels???? On top of the disastorous US biofuel policies, do we wonder why grain commodity prices have soared? Sure hope not. Interest rate related? Maybe in part.
    Does the interest rate theory explain contango and backwardation? Can it confront the current oil market in which 80% of reserves are controlled by entities who have no interest in long term profitability.
    And how would this theory deal with the piling on of “speculative” investors who favour “momentum theories”?
    Finally, the second chart purports to demonstrate the relationship between real interest rates and commodity prices; the drawn line may have some theoretical value, but as an (niave?) investor it appears to have a curious (incestuous perhaps?) relationship.

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