The commodities we are concerned with here are those with potentially very low storage costs. Minerals, when kept in the ground, have a storage cost next to zero. I observed a strong link between the evolution of the market price of minerals and the slope of the yield curve. The slope of the yield curve indicates the preference of the market between short-term assets and long-term assets.
Attention: My model says a yield curve is normal if the differential between long-term rates and short term rates pay exactly for the interest risk (market indifference). It is steep if the differential between long-term rates and short term rates pay more than the interest rate risk (market preference for long-term assets). It is inverted if the differential doesn't pay for the interest rate risk. As a result, a yield curve may have a positive slope and still be inverted, contrary to the general perception.
When
the yield curve is inverted, because of profit maximization, Miners & Drillers, as a group, prefer hoarding a higher proportion of their
minerals in the ground (their preferred short-term assets) rather than
extracting them and investing the proceeds in long-term instruments. Hence,
the marginal cost of extraction of minerals becomes irrelevant to their
market price as miners stop maximizing their output under the constraint:
Market Price - Their Marginal Cost of Extraction > 0 . Reminder:
the Chart
of the Slope of the Yield Curve click to enlarge all images Profit
maximization would have them trying to retain a higher proportion of
their minerals in the ground rather than extracting them. The quality of
the index, the slope of the yield curve, is superior to any other known
system. Need
for a Global Parameter: The price of minerals has grown unabated since
the yield curve started being inverted with acceleration when the Federal
Reserve started increasing short-term rates from 1%. At that time,
long term interest rates were so low that the yield curve became inverted
when the short term rates reached 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. Chart of Oil and
EuroDollar Chart of Gold and EuroDollar This
correlated increase in the price of minerals must be caused by a global
parameter. Harvard Economics Professor Jeffrey Frankel, in Monetary
Influences on Commodity Prices, a summary of The Effect of Monetary Policy
on Real Commodity Prices, 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 and still minerals kept growing.
Storable from an industrial point of view should be different than from
an economic point of view: if you need to build a Fort Knox, hire people
to handle your stock and guard it; your cost might be higher than any
expected revenues. 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. The low
interest rate argument doesn't hold as you can always sell the commodity
on futures markets and earn the short-term interest rate. As a result,
there is an implied short-term interest rate embedded in a commodity. The Hidden Parameter: Interpretation of the
Yield Curve A normal yield curve means that the market is indifferent between long-term and short-term assets (neutral monetary policy). A
steep yield curve means that the markets prefer long-term assets over
short-term assets (accommodative monetary policy). An inverted yield
curve means that the market prefers short-term assets rather than long–term
asset (restrictive monetary policy). Financial decisions are always
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 prefer to hold minerals The shape of the yield curve
is paramount in any financial decision, rather than long-term
assets. “Inventory
accumulation is likely to continue unless demand rises, output declines, or we run out of storage capacity.” (Remarks by Chairman Alan Greenspan on Energy before the Economic Club of New York, NY, New York, May 20, 2005) Hence,
miners would keep a higher proportion of their minerals in the ground
where storage is infinite and almost free to them (for a miner, the best
short-term asset is minerals in the ground, so selling them in order
to buy short-term financial assets is simply not relevant), rather
than sell them and invest the proceeds in long-term assets. Because
of their self-restraint on output, hence on supply, they generate as the commodity price rises, which is compounded with the increase in their
unrealized revenues. That behavior need not be conscious but is probably
the result of the propagation of arbitrages through the different financial markets, among them the cash and derivative markets on fixed income
securities and the cash and futures markets for minerals. Circumstantial
evidences: How else would we understand that, over such a short period
of time, the cost of oil was multiplied by 5, with a low depletion of
the proven reserves? How else would we understand that all the minerals
saw their costs rising in the same period with a next to perfect correlation?
It 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. Reminder:
the Marginal Cost of Extraction does not include fixed cost (i.e.
exploration cost, cost of an offshore platform, etc...). 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. Term
Structure of Forward Prices: In their work, Equilibrium Forward Curves
for Commodities, Bryan R. Routledge & Duane J. Seppi & Chester
S. Spatt charted the forward curves for high and low demand for commodities. Term
Structure of Forward Prices of Commodities With
high demand and increasing prices, the slope of carry rate is negative and
the implied interest rate decreases, which suggest that the yield curve
is decreasing: it is coherent with a reversed yield curve. With low
demand and decreasing prices, the slope of carry rate is positive and the
implied interest rate decreases, which suggest that the yield curve is
increasing: it is coherent with a normal or steep yield curve. Price
movements: Should the yield curve on the U.S. dollar return to normal,
as it did on Monday, March 13th, 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. Should the yield curve stay normal
or steep for a protracted period of time, the price of commodities would
reach its marginal price of extraction. According to my hypothesis,
that price must be much lower than the expectation of all market participants.
Because most of the hedge funds holding are outside the ground, they
are not constrained by the marginal cost of extraction; should the price
of mineral go down, we should see some overshooting, in particular in
minerals with low industrial use: gold and silver. Graph
of the Normal Slope vs. Short-Term Interest Rate My model of the yield curve comes from empirical observations over a 14
year time span. It is backed by a modified work of one of the most
respected and reliable academics in the field of mathematical finance.
The modification was simply the relaxation of one parameter which the
researcher himself didn't use in his other related work. The Minerals
Paradox: A restrictive monetary policy increases the price of minerals,
including oil, and participates in the building up of inflation.
Precision of the Model: The precision of my model of the yield curve
varies from 1 basis point to 5 basis points. A change of one basis point
around the normal curve means a movement of several dollars of the price
of the minerals in one direction or the other. Timeliness: The reaction
of the mineral markets to a twist of the slope of the yield curve around
its normal value varies from instantaneous to one hour. Measure of the Quality
of the Decision: The steeper or the more reverse the slope of the yield
curve, the more stable the price movement. In that sense, it can allow
for safer trades and to calibrate the size and risk of their exposure.
Because short-term yields and long-term yields have a high correlation,
the dynamic of the slope of the yield curve is slow, which allows the
trader to make better decisions with less pressure. Asymmetry of the
Price Movements: My model implies that when the curve is normal or steep,
the fall of the price is much faster than the rise of prices when the
curve is inverted. Higher Limit of Mineral Prices: Under this framework,
there is no theoretical higher limit of the price of the minerals, however,
should the yield curve become normal or steep, the fall of the price
would be accelerated by the difference between market price and marginal
cost of extraction. Caveat: "Risk management
involves judgment as well as science, and the science is based on the
past behavior of markets, which is not an infallible guide to the future." (Remarks by Chairman Alan Greenspan, Risk Transfer and Financial Stability, To the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois (via satellite), May 5, 2005) Funds
liquidations: My model supposes that the market is driven by the
miners. If the market falls sufficiently in order to cause wide
fund liquidations, it stops working; the funds don't have a zero cost
of storage and they are not governed by the shape of the yield curve. Hence,
the market can fall with a reversed yield curve. The model will return
to its operational work on any significant technical rebound. In that
case, the trader must use his own judgment and try to gauge the size
of fund liquidation. Large positions: A trade when the yield curve is
normal is rewarding, but the risk to see the yield curve revert to inverted
can be sudden: it is not fit for large positions. Connected markets:
The ethanol, and in a lesser proportion, corn and wheat markets, because
of the agricultural surface they displace, have some positive correlation
with the market for minerals; however, my experience tells me that fund
managers should stick to minerals where the connection with the slope
curve is the strongest. Portfolios: In order to shield from specific
risk when a particular mineral price is influenced by some random news,
it is advisable to use a portfolio of minerals rather than one specific
mineral. References:
My Hypothesis is Different
Conclusion
