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.

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 of hedge funds holding, 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

A more likely explanation for the increase in commodity prices is the movement from global liquidity from an asset bubble in equities, to real estate, which has now settled in commodities. This would explain the recent run up in gold to over $1000 an oz. Cuts in interest rates have accompanied the deflation of the asset bubble, but this does not mean they are a direct result of low rates. Correlation does not necessarily prove causation.

The Fed’s aggressiveness, obviously, has produced no real results (other than inflation pressure) and this is why.

The informal Bretton Woods II agreement between oil exporters and Asian manufacturers either through their quasi-US dollar pegs or through concerted intervention simply meant that they were artificially keeping their currencies weak against an already weak US dollar that subsequently weakened further. Hence why almost all asset prices rose globally from Shanghai to sugar.

The 25% kicker we got in commodities since the Fed eases in the third week in January was merely a desperate attempt by investors into the last asset class left standing as a hedge against falling financial asset prices elsewhere and as a hedge against a weak US dollar and future inflation expectations going forward.

Those gains are now retracing as traders realize that firms struggling with growth and profitability will be hurt by those higher input prices at a time when they have very little pricing power. But it is still worth remembering that $12 wheat in 2008 is equal to $1.69 per bushel in 1958 inflation-adjusted US dollars. Commodity prices relative to say houses are still historically very low!

Happy Easter!

Bill.

If you took out those three points and the line you drew in, how many people would draw the relationship as you have? Not too many I suspect, and I bet the regression package you use would confirm that it is a pretty useless model.

THat isnt to say that your theoretical argument is wrong - but there is a lot more going on than your argument can explain