IAUM - Higher-For-Longer Interest Rates: The Potential Impact On Commodity Markets

2023-08-29 13:20:00 ET

Summary

• What higher rates could mean for oil and gold.
• Oil's rise and its impact on inflation.
• China's weakness continues to be a headwind for commodities.

Fed Chair Jerome Powell is signaling he stands ready to raise interest rates again if inflation pressures remain. Bart Melek, Global Head of Commodity Strategy at TD Securities, speaks with Greg Bonnell about the potential impact on commodities and the implications for investors.

Transcript

Greg Bonnell: Fed Chair Jerome Powell has signaled that rates may be higher for longer as inflation remains a bit sticky. So what does that mean for the commodity space going forward? Joining us now to discuss, Bart Melek, Global Head of Commodity Strategy with TD Securities. Bart, great to have you back on the program.

Bart Melek: Great to be here. Thank you for inviting me.

Greg Bonnell: So we've wrapped another Jackson Hole. Jerome Powell came out. He gave his speech. They seem to be staying the course. Listen, the fight from inflation -- it's positive, but it's far from over. Rates will be up for a while. What are we thinking in terms of commodities?

Bart Melek: Well, this is, I think, for the most part, somewhat negative for commodities. Gold, copper, even oil probably won't respond overly favorably, though oil has its own set of drivers on the supply side that will protect it from the impact of interest rates. But for the most part, higher interest rates essentially mean higher cost of carry and higher cost of opportunity costs for commodity holders.

On the margin, that implies you might want to hold lower inventories. You might want to go lease out things like cop -- gold, like silver to the broader market and make physical metal more available. So, all in all, it is a negative.

To what extent it is a negative will very much depend on how high rates go and how long they stay there. The higher they go, the more negative it is. The longer they stay there, obviously, is somewhat more negative. At this point, I think we're still unsure of how high they go and for how long they stay up there.

Greg Bonnell: At this stage of the hiking cycle, we're actually in a place where we have people talking about real rates and the effect that might have. I think we have a picture we can show the audience, so you can help explain to us rising real rates weighing on gold.

Bart Melek: Yes. Typically, that's true. When we look at gold, and when we look at the variables that impact gold, real rates are probably the most --

Greg Bonnell: Telling?

Bart Melek: --the most telling, yeah. It's one of the biggest indicators of how gold will do. And certainly, over the short run, as the Federal Reserve keeps rates at -- whether it's 550 or somewhat higher for a prolonged period, and inflation starts moving lower, ironically, what you will likely get is even higher real rates. So real rates are really just defined as nominal rates less inflation.

So for a time, as inflation drops, the policy actually gets tighter, even if the central bank doesn't do anything, even if they hold rates steady, even if they drop it a little bit. And depending on the rate at which inflation drops, the environment could become more restrictive in that circumstance, so that could be quite a negative. We're, of course, betting that the Fed will start moving in the first three months of next year in March, but we're still not sure how core inflation and how inflation respond. But for now, as inflation drops, that could actually be worse for the market than I think most people realize.

Greg Bonnell: That's the best explanation I've heard of real rates and how they pass through the economy in a long time, so thanks for that. The audience thanks you for it. Let's talk about oil. You talk about oil having, of course, feeling the weight of higher rates but having its own factors as well. We got oil above $80 a barrel right now on my screen. I mean, that can be inflationary too.

Bart Melek: Well, certainly. In fact, for the last two months, we've seen significantly higher oil prices. But as far as inflation is concerned, it's not really oil that drives us. It's gasoline and diesel. None of us put actual oil in the gas tank because it probably would break the car. We put refined products in, and those have actually outperformed the crude market.

And part of the reason here is that inventories are very, very low, particularly, on the heavier -- on the middle distillate side. So as we move forward -- and we're still looking at an increase in demand of some 2 million barrels per day this year -- not only will we have to satisfy that demand to fill your car up to run industry, but we're also going to have to run crude through the refining system to try to lift those inventories. So that puts a bigger stress on the demand side than, I think, otherwise.

So it's not just current demand. It's also extra demand to refill those very low inventories. Right now, crack spreads are quite high. And that's just the premium, if you like, of products versus the input, the oil, are quite high. I think, for diesel, as much as close to $50 or so.

And that means that there's a lot of incentive on the part of refiners to process as much crude as they possibly can because they're making a good buck out of it. So why not? And inventories are low. They don't have to really worry about prices collapsing anytime soon. Demand is firm.

So as we move into the winter time, as we use oil for heating and so on, we could see that spread continue to be quite robust. And that will continue, also, to drive demand over and above what the macroeconomy is doing. And, of course, we are facing some challenges on the macroeconomy with higher rates. Many people, including us, are talking about a recession in the United States. China -- well, China --

Greg Bonnell: Let's bring up China, right, because I feel like this has been like the economic elephant just sitting off here to the side as we discussed these other issues. The economy is not going gangbusters there, and they're not doing all that much. A few things around the margins to try to get it going again.

Bart Melek: Well, we haven't seen really aggressive stimulus. There are those who think that that will come. But so far, we've seen very modest measures.

We'll see what happens. I suspect the worse things get, the more stimulus you will get. But China has a big problem with youth unemployment. Young people are facing a lot of problems finding jobs. They've, if you recall, have kept the economy shuttered for a lot longer than anyone else. And we didn't see the sort of government supports that we've seen in the Western world.

And what that has done, I think many believe, that confidence has been eroded a great deal. We're seeing that in general consumption. We're seeing that very much in the real estate market, which is a very big user of commodities.

And it's going to take a while. But still, the fact of the matter is, people are no longer locked up in their house. So it's better than it was during COVID, but I think many observers are quite disappointed with the broad numbers.

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