What Interest Rates Mean to Commodity Economic Cycles

By Sharp, Eric L. | Futures (Cedar Falls, IA), October 1989 | Go to article overview
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What Interest Rates Mean to Commodity Economic Cycles

Sharp, Eric L., Futures (Cedar Falls, IA)

What interest rates mean to commodity economic cycles The fact that the Federal Reserve Board has been fighting inflation in the United States during 1989 has important implications for a number of commonly traded futures markets.

Inflation is always trying to get a foothold in a growing economy. When the Fed finds inflation is becoming a problem, it takes steps to push up short-term interest rates, and the economy usually cools. When the economy slows, prices drop for an assortment of underlying items for which futures are traded.

In carrying out its regular policies, the Fed's main effect is on short-term interest rates. When it wants to slow the economy, the Fed acts to impede bank lending with actions that push short rates up to and beyond long ones. That results in what's known as an "inverted yield curve."

Spread indications

A good way to monitor the Fed's policies is to watch the spread between the Fed funds rate and the 10-year Treasury bond yield. The Fed funds rate is the rate at which banks loan funds to each other overnight to maintain their reserves. Its level is a direct reflection of Fed policies. When the Fed is serious about slowing the economy, it forces the Fed funds rate above bond yields, creating a positive spread between the two.

During the post-war era, the United States has witnessed seven episodes of excessive inflation countered with a positive yield spread between Fed funds and T-bonds. An economic slowdown followed each time.

After the slowdown period, the Fed loosened its grip, and the spread became normal as growth resumed.

The eighth such episode is currently taking place.

With that in mind, let's look at how the economy and commodity prices reacted to past tightenings.

The series of charts on the next page shows the spread between Fed funds and T-bonds (bottom) along with the Index of Industrial Production (top) and several examples of key markets in which futures are traded.

The Index of Industrial Production is based on monthly physical output of manufacturers and utilities. This index can perform as a good proxy for gross national product, which is released only quarterly.

The correlation between the index and Fed policy is quite unmistakable. Every period of tight money conditions in the United States is seen to correspond to a decline in the growth rate of industrial production.

Note than in the late 1940s and early 1950s a narrowing of the spread, without going to the extent of actually turning positive, was enough to trigger slowdowns.

Inflation grew progressively harder to suppress up to and including the last tight episode in the early 1980s.

Most major, sustained stock price drops are due to two basic factors.

The first is tight money conditions. Stocks are discounted against interest rates, and increased rates hurt stock prices. Tightenings also mean an economic slowdown, which brings less sales and lower corporate profits -- all hurting stock prices.

Second, stocks tend to grow overvalued toward the end of a business expansion, having high price-to-earnings (P/E) ratios and low yields.

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