An Age-Old Relationship Between Interest Rates and Prices

By Steve Saville

When money is sound, interest rates don’t drive prices and prices don’t drive interest rates

The chart displayed near the end of this discussion is effectively a pictorial representation of what Keynesian economists call a paradox* (“Gibson’s Paradox”) and Austrian economists call a natural and perfectly understandable relationship.

Gibson’s Paradox was the name given by JM Keynes to the observation that interest rates during the gold standard were highly correlated to wholesale prices but had little correlation to the rate of “inflation”, that is, that interest rate movements were connected to the level of prices and not the rate of change in prices. It was viewed as a paradox because most economists couldn’t explain it. According to conventional wisdom, interest rates should have been positively correlated with the rate of “price inflation”.

The problem is that most economists did not — and still do not — understand what interest rates are.

First and foremost, interest rates are the price of time. They reflect the fact that, all else being equal, humans place a higher value on getting something now than on getting exactly the same thing at some future time. Interest rates transcend money, because they exist even when money does not. With or without money and all else being equal, getting something now will always be worth more than getting the same thing in the future**. This is called time preference.

Time preference is the root of interest rates and the natural interest rate is a measure of societal time preference. That is, the natural interest rate is a measure of the general urgency to consume in the present or the amount that would have to be paid, on average, to make saving (the postponement of consumption) worthwhile. For example, the average 7-year-old child has a very high time preference, in that if you give the kid a choice between getting a desirable toy today or getting something more in 3 months’ time, the “something more” option won’t be chosen unless it is a LOT more, whereas a middle-aged adult with substantial savings is likely to have low time preference.

When interest rates are properly understood it becomes clear that the paradox named after Gibson is no paradox at all. The reason is that if the money is sound, as it mostly was under the Gold Standard, both interest rates and prices will move in the same direction in response to changes in societal time preference.

To further explain, during a period of rising time preference, that is, during a period when there is an increasing desire to consume in the present, the prices of goods will rise (on average) due to increasing demand and it will take a higher interest rate to encourage people to delay their spending. During a period of falling time preference, that is, during a period when there is an increasing desire to save, the prices of goods will fall (on average) and people will generally accept a lesser incentive (interest rate) to delay their spending.

In a nutshell, there is no paradox because, when the money is sound, interest rates don’t drive prices and prices don’t drive interest rates; instead, on an economy-wide basis*** both prices and interest rates are driven by changes in societal time preference.

Continue reading An Age-Old Relationship Between Interest Rates and Prices

High AMO Says Rates Should Stay Low

By Tom McClellan

High AMO Says Rates Should Stay Low

AMO versus interest rates
January 20, 2017

The Atlantic Multidecadal Oscillation (AMO) is a bit of data that climate researchers use in their modeling of global climate change.  And it turns out that it has interesting messages for us about the long term trends in interest rates.

I will spare you all of the details of the AMO’s computation, but you can download the data yourself at NOAA’s web site, and read more about it at this page.

What we can see in the chart above is that there does seem to be a relationship between interest rates and global temperatures as modeled by the AMO.  The data on AMO only go back to 1856, so we cannot yet see this relationship through multiple iterations of the 60-year cycle.  To help illustrate this correlation better, I have offset the AMO data forward by 6 years.  Why there is that 6-year lag is not something I can answer.

Climate scientists have long known that there is a 60-70 year cycle in global temperatures and other related data.  And bond market analysts have long known about the 60-year cycle in interest rates.  But these two groups of experts rarely talk to each other, nor look up this period’s other usages throughout the ages.  A quick Google search shows lots of other 60-year periods of interest to people.

60-year cycles

My understanding is that the basis for the relationship between temperatures and interest rates lies in agriculture.  Warmer global temperatures are better for crop production, lengthening growing seasons and reducing drought length and severity.

Continue reading High AMO Says Rates Should Stay Low

Lumber’s Message For Interest Rates

By Tom McClellan

Lumber’s Message For Interest Rates

Lumber's leading indication for 2-year T-Note
December 15, 2016

The FOMC is now finally allowing interest rates to start moving where the market has already said they should have gone.  The 2-year T-Note Yield is already up to 1.27%, and the Fed is lagging behind in making an adjustment.  I have shown before that this can be a problem, having the Fed lag behind the message from the 2-year T-Note yield.

The important message that the Fed apparently does not have any awareness of is that there are many more rate hikes in store.  This week’s chart shows how lumber prices tend to know what the Fed should do well ahead of the FOMC being aware.  In the chart above, we can see that the 2-year T-Note yield tends to follow the path of lumber futures prices, with a lag time of about a year.

The fact that lumber prices have been trending higher over the past year conveys the message that interest rates should trend higher in 2017.  This principle works most of the time, although when the Fed puts a thumb on the scale, the correlation can go awry.

The announcement on Dec. 14 of another quarter point rate hike suggests that the Fed is getting out of the thumb-on-scale mode, at least a little bit.  And that should allow interest rates to follow the upward path of lumber prices in 2017.

So now you’re wondering: won’t higher rates have a negative effect on home purchases, mortgages, etc.?  The answer is, yes of course.  But not right away.  It turns out that lumber prices also lead several data series related to housing, including the prices of housing stocks.

Lumber leading indication for HGX Index

The next year should see rising prices for stocks related to homebuilding, as represented by the HGX Index.  That might seem to be in conflict with the notion of rising interest rates, since higher rates make buying a home less affordable.  But higher demand for housing tends to push up both home prices and home mortgage rates.

And there is a perverse kicker.  Those nascent home buyers who have been on the fence about whether it is time yet to pull the trigger may see that the rising rates are taking their home affordability away, and so they could get in a rush to buy while they still can.

Economics is funny that way.  The basic premise is that “people respond to incentives” but they do not necessarily have to respond in exactly the way that the economists determine that they should.

The bottom line is that higher lumber futures prices have meaning for both interest rates and housing related stocks’ prices.  And that message right now is about higher interest rates in 2017, and higher prices for housing related stocks.

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Related Charts

Nov 19, 2015

Housing Starts – Lumber’s Message
Sep 22, 2016

Bond Market Knows What Fed Should Do
Mar 30, 2012

Lumber Says This Is A Top For Housing Stocks

Chart In Focus Archive

Will the Dollar and Higher Rates Doom Stocks?

By Chris Ciovacco

Dollar Breaks Out

With the Fed flip-flopping on interest rates, the U.S. dollar traded inside a two-year consolidation box, which is indicative of indecisive investor behavior. The dollar was recently able to break to the upside with market participants expecting a Fed rate hike in December.

Impact On Multinationals And Consumers

There are valid concerns tied to a rising U.S. dollar. A strong dollar makes American goods more expensive overseas, which can negatively impact earnings for multinational companies. However, the flip side of that coin is U.S. consumers will pay less for imported goods, allowing them to have more disposable income.

What Can We Learn From History?

This week’s video explores the question:

Is it in the realm of historical possibility for stocks to perform well in periods marked by rising interest rates and a strong U.S. dollar?

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.Video


Higher Rates Can Impact Capital Flows

Bonds have recently sold off on expectations for stronger growth, higher inflation, and higher interest rates. The selloff in bonds and the post-election push higher in stocks have allowed the stock/bond ratio to break out of a long-term consolidation box (see chart below). The impact of capital flows between stocks and bonds was covered by The Fat Pitch:

In July, fund managers’ had their highest exposure to bonds in 3-1/2 years. In other words, they expected yields to keep falling. Instead, yields reversed higher and have since risen so sharply that several smart money managers now say that a new secular uptrend in yields is taking place. That is a big call, given that the foregoing secular downtrend has lasted more than 35 years.

Over the past 18 months, investors’ money has been flowing consistently out of equity funds. Where has that money gone? Mostly to bond funds. Money usually follows performance, so it’s a good guess that fund flows might soon begin to favor equities. If past is prologue, then equities should gain and bond yields should continue to rise. Whether that will constitute the start to a new secular uptrend for yields it is far too early to say.

Financials Have Responded

Since bank earnings are impacted by interest rate spreads, higher interest rates tend to be positive for the financial sector. President-elect Trump’s platform also calls for toning down regulations from the post-financial crisis Dodd-Frank legislation. Financial stocks have responded by breaking out from a multiple-year base relative to the S&P 500.

Time Will Tell

As long as the markets are moving based on the higher growth, higher inflation, and higher rates theme, economically-sensitive areas of the market, such as small caps (IWM), mid caps (MDY), metals (JJC), and consumer discretionary (XLY), will most likely continue to outperform more-defensive oriented areas, such as bonds (TLT), gold (GLD), and utilities (XLU). Stocks have come a long way in a short period. Even under longer-term bullish conditions, some “give back” is to be expected.

Gold and the Real Interest Rate

By Steve Saville

The ‘real interest rate’ has temporarily become a headwind for gold

The real interest rate is one of gold’s true fundamentals, with a rising real interest rate exerting downward pressure on the gold price and a falling real interest rate exerting upward pressure on the gold price. However, it is important to keep in mind that the real interest rate is just one of several fundamental drivers of the gold price.

Due to the relationship between gold and the real interest rate, the gold price will often trend in the opposite direction to the 10-year TIPS yield. This is because the TIPS yield is a practical, albeit not theoretically correct, proxy for the real interest rate. For example, the sharp rise in the TIPS yield between March and November of 2008 (Period A on the following chart) coincided with a substantial downward correction in the gold price, and the multi-year decline in the TIPS yield from its November-2008 peak coincided with a powerful upward trend in the gold price.

Note, though, that the downward trend in the TIPS yield continued until September of 2012 whereas the gold price peaked in September of 2011. The period of divergence is labeled “B” on the following chart.

That the gold price stopped trending with the real interest rate for 12 months beginning in September of 2011 is related to the real interest rate being only one of several (six, to be specific) fundamental drivers of the gold price*. Other fundamental price drivers turned bearish during the second half of 2011 or the first half of 2012, thus counteracting the bullish influence of the declining real interest rate. That being said, substantial weakness in the gold price didn’t show up until after the real interest rate began to trend upward.

The real interest rate reached its post-2011 peak in December of 2015 — at around the same time that the Fed made its initial rate hike. The December-2015 downward reversal in the real interest rate marked the start of an intermediate-term rally in the gold price.

The most recent low in the real interest rate occurred in early-July (the end of Period C on the following chart) and coincided almost to the day with gold’s price top.


Prior to the Trump election victory there was no way of knowing whether the choppy sideways move in the real interest rate since early-July was a ‘pause for breath’ within a continuing downward trend or the start of a new upward trend. Prior to last week I therefore viewed this particular gold-market fundamental as neutral. It had stopped being a tailwind, but it hadn’t become a headwind.

The next chart shows that one consequence of last week’s post-election volatility was an upside breakout by the 10-year TIPS yield from its 4-month range. This means that the ‘real interest rate’ has temporarily become a headwind for gold.


The TIPS yield is just one of six true fundamental drivers of the US$ gold price, but the post-election shift in this one indicator tipped (no pun intended) the overall fundamental balance from neutral to slightly-bearish for gold. This won’t prevent a multi-week rebound in the gold price, but the next major rally won’t begin until the fundamental backdrop has become more supportive.

*The other fundamental drivers of the gold price are the US yield curve (as indicated by the 10yr-2yr yield spread), credit spreads (as indicated by the IEF/HYG ratio), the relative strength of the banking sector (as indicated by the BKX/SPX ratio), the US dollar’s exchange rate and the overall trend for commodity prices.

Morning Market Report – Interest Rates


Interest Rates

interest ratesDecember T-bonds closed up 31 (32’s) at 155-08.

December T-bonds closed higher on Wednesday as it consolidated some of this month’s decline. The high-range close sets the stage for a steady to higher opening when Thursday’s night session begins trading. Stochastics and the RSI are turning neutral to bullish signaling that sideways to higher prices are possible near-term. Closes above the 20-day moving average crossing at 160-30 would confirm that a short-term low has been posted. If December extends this year’s decline, the November 2015 low on the weekly continuation chart crossing at 151-12 is the next downside target. First resistance is the 10-day moving average crossing at 158-09. Second resistance is the 20-day moving average crossing at 160-30. First support is Monday’s low crossing at 152-24. Second support is the November 2015 low on the weekly continuation chart crossing at 151-12 is the next downside target.

December T-notes closed up 40 /32’s at 126-175.

December T-notes closed higher on Wednesday as it consolidated some of this month’s decline. The high-range close sets the stage for a steady to higher opening on Thursday. Stochastics and the RSI are oversold but remain neutral to bearish signaling that sideways to lower prices are possible near-term. If December extends this year’s decline, the 75% retracement level of the 2013-2016-rally on the weekly continuation chart crossing at 125.060 is the next downside target. Closes above the 20-day moving average crossing at 129.022 would confirm that a short-term low has been posted. First resistance is the 10-day moving average crossing at 128.062. Second resistance is the 20-day moving average crossing at 129.022. First support is today’s low crossing at 125.285. Second support is the 75% retracement level of the 2013-2016-rally on the weekly continuation chart crossing at 125.060.

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Introducing Yield Purchasing Power

By Keith Weiner

In the cold harsh light of yield purchasing power, we can see the erosion of our capital base

The monetary debate seems artificially limited. On one side is Federal Reserve policy based on discretion. On the other is policy based on rules. It’s Keynes vs. Friedman. It’s central planning of our economy based on the reactive whims of wise monetary planners vs. central planning of our economy based on the proactive rules written by … wise monetary planners.

On the rules side, there is a sub-debate. Should we have central planning based on unemployment and the Consumer Price Index (as now) or switch to central planning based on another metric such as GDP?

Whether one is on team Keynes or team Friedman, whether one is on sub-team Friedman CPI or Friedman GDP, everyone seems to take something for granted. That is, the quantity theory of money. If the quantity rises, then prices follow. However, since prices (especially commodity prices) are not really rising, this would seem to give more leeway to the monetary planners, to inflict more monetary policy on us.

There is something about this which few acknowledge. To increase the quantity of dollars—which is not money, but that’s a whole ‘nother discussion—the Federal Reserve buys bonds. Whatever effect this may have on the price of a new Chevy, it obviously affects the price of the Treasury bond. It pushes the bond price up. Since the interest rate is a strict mathematical inverse of the bond price, we have an obvious conclusion.

The Fed is pushing down the rate of interest.

We can say that the interest rate is the collateral damage. The Keynesians and Friedmanites, in their zeal to increase the quantity of dollars, support or at least ignore the falling interest rate. OK, but who cares about the interest rate? You should care. Everyone is impacted by the 35-year global trend of falling interest rates.

The falling rate ushers in a kind of hyperinflation. You won’t see it by looking at prices, or purchasing power. If you look at the value of your portfolio and divide by the cost of living, you may be lulled into a false sense of security.

You will see the hyperinflation, if you look at it another way. Instead of the liquidation price of assets, consider the yield on assets. Instead of selling off the family farm to buy groceries, think of operating that farm to grow food. Can you live on the crops you produce? Or must you liquidate piece of it, just to survive?

The same question applies to any capital asset including a bank balance. Is it possible to live on the interest?

In the cold harsh light of yield purchasing power, we can see the erosion of our capital base. Since civilization itself depends on capital accumulation, this erosion is a retrogressive force dragging us back to another dark age.

I gave a 45-minute presentation on Yield Purchasing Power at American Institute for Economic Research in Great Barrington, MA on October 14, 2016. I am grateful to the Institute for recording video of my presentation plus extended Q&A.

Fischer Says Fed Needs Help Regarding Low-Rate Risks

By Chris Ciovacco

What Message Was Embedded In Fischer’s Entire Speech?

Human beings tend to look for data that supports their personal bias. This concept applies to interpreting information coming from the Federal Reserve. It would be easy to find portions of Vice Chairman Stanley Fischer’s remarks that support the case for raising rates as well as the case for holding rates steady for the remainder of 2016.

Fischer Says Low Rates Are Concerning

In Monday’s speech, Fischer enumerated concerns that are tied to an extended period of near-zero interest rates:

There are at least three reasons why we should be concerned about such low interest rates. First, and most worrying, is the possibility that low long-term interest rates are a signal that the economy’s long-run growth prospects are dim.

A second concern is that low interest rates make the economy more vulnerable to adverse shocks that can put it in a recession.

And the third concern is that low interest rates may also threaten financial stability as some investors reach for yield and compressed net interest margins make it harder for some financial institutions to build up capital buffers.

Does It Imply The Fed Needs To Hike Rates?

If the Fed Vice Chair comes out and says there are serious concerns about having low interest rates for an extended period of time, then it is logical to imply the Fed’s Vice Chair is in favor of hiking rates in December. However, the text of Fischer’s speech makes it clear that it is not that easy:

Now, I am sure that the reaction of many of you may be, “Well, if you and your Fed colleagues dislike low interest rates, why not just go ahead and raise them? You are the Federal Reserve, after all.” One of my goals today is to convince you that it is not that simple, and that changes in factors over which the Federal Reserve has little influence–such as technological innovation and demographics–are important factors contributing to both short- and long-term interest rates being so low at present.

Some Areas Are Outside Of The Fed’s Control

If Fischer believes successfully pushing interest rates higher is not as “simple” as the Fed hiking rates, what areas did he focus on during Monday’s speech? Excerpts from his prepared remarks provide some insight:

What might contribute to raising longer-run equilibrium interest rates?

  1. An improvement in animal spirits
  2. Expansionary fiscal policy (examples: boost government spending by 1 percent of GDP or cuts taxes by a similar amount.)

In summary, a variety of factors have been holding down interest rates and may continue to do so for some time. But economic policy can help offset the forces driving down longer-run equilibrium interest rates. Some of these policies may also help boost the economy’s growth potential.

Fed Desperately Wants Higher Rates

With rates near zero, central bankers are probably not sleeping very well given the limited ammunition they have to fight the next recession. The Fed wants to raise rates to put some bullets back in their chamber, but they don’t want to push the economy into a recession via an ill-timed rate hike. Based partly on the fear of hiking too soon, Janet Yellen’s remarks last Friday contained an easy to discern dovish tone. Fischer’s speech basically asked for fiscal help from Congress, something that has been absent for quite some time.

Stock Market Maintains Indecisive Stance

An October 12 article contained four charts outlining some key areas for the stock market. An updated version of one of the charts is shown below. Early in Tuesday’s session, the S&P 500 remained above several “we will learn something either way” levels.

Bond Market Knows What Fed Should Do

By Tom McClellan

Bond Market Knows What Fed Should Do

Fed Funds rate versus 2-year T-Note yield
September 22, 2016

This article first appeared in McClellan Market Report #515, published Sep. 21, 2016, and reflects a theme we have reported on multiple times before. 

We have an unblemished 21-year track record of predicting what the Fed should do, with 100% accuracy.  What the FOMC actually does is often different from what it should do.  As of the Sep. 21 FOMC meeting announcement, the Fed has missed another chance to do the right thing.

There is only one reason why the FOMC should ever change the Fed Fund target rate, and that is if the rate is in the wrong place.  Deciding what is the right or wrong rate is really difficult to do if all you do is look at economic data and complex models with Greek-letter math.  It is a lot easier if you just look at the bond market.

We have long held the belief that the FOMC should just outsource the task of setting the Fed Funds rate, and give that job over to the 2-year T-Note yield.  The chart above compares those two, and makes the point that the further apart they are, the bigger the problems that the Fed is creating.  Problems can result from being too restrictive, or too stimulative.  Right now, they are being too stimulative (and punishing savers).

Continue reading Bond Market Knows What Fed Should Do

Using Statistics to Distort Reality

By Steve Saville

Two months ago I posted a short article in which I discussed an example of how the change in an economic statistic was greatly exaggerated — in order to paint a misleading picture — by showing the percentage change of a percentage. I’ll now discuss another example of using the same trick to make the change in an economic number seem far more dramatic than was actually the case.

Before getting to the specific example, the general point is that when analysing economic data — or any other data for that matter — it won’t make sense to consider the percentage of a percentage unless it’s the second derivative that you are primarily interested in. When you take the percentage change of a percentage you cause a change in the underlying number from 0.5 to 1.0 to become the same as a change in the underlying number from 5 to 10 or 100 to 200, but in the real world the change in an economic number from 5 to 10 will usually have vastly different implications to the change in the same number from 0.5 to 1.0. For example, there is a huge difference between a change in the rate of GDP growth from 0.5% to 1.0% and a change in the rate of GDP growth from 5% to 10%, but both constitute a 100% increase in the rate of growth.

On a related matter, it can also be problematic to look at percentage changes of economic numbers when the numbers are fluctuating near zero. This is because a move from one miniscule value to another can be large in percentage terms. For example, a move from 0.01 to 0.03 is a 200% increase.

The specific example that prompted this post appeared in John Mauldin’s recent article titled “Negative Rates Nail Savers“. The gist of the Mauldin piece is completely correct, but during the course of the long article some mistakes were made. I’m zooming-in on the mistake contained in the following excerpt:

Here is a long-term chart of the federal funds rate, the Fed’s main policy tool:

The gray vertical bars represent recessions. You can see how the Fed has historically dropped rates in response to recessions and then tightened again when those recessions ended. I red-circled the particularly drastic loosening and retightening under Paul Volcker in the early 1980s and Ben Bernanke’s cuts to near-zero in 2008.

To this day, the Volcker rate hikes are legendary. No Fed chair has ever done anything like that, before or since. You hear it all the time. Problem: it’s not true.

Here is the same chart again, this time with a log scale on the vertical axis. This adjusts the rate changes to be proportionate with percentage rises and falls. The percentage change between 5% and 10% is the same as between 10% and 20%, since both represent a doubling of the lower number.

Looking at it this way, the Volcker hikes are tame, almost unnoticeable. Meanwhile the Bernanke cuts dwarf all other interest rate changes since 1955. Nothing else is even close. Bernanke’s rate cuts were far, far more aggressive than Volcker’s rate hikes.

The fact that looking at it this way “the Volcker hikes are tame, almost unnoticeable” should have told Mr. Mauldin that it was the wrong way to look at it. Moreover, looking at it Mr. Mauldin’s preferred way, even the tiny up-tick in the Fed Funds Rate last December makes Volcker’s hikes seem tame. After all, when the Fed nudged the target Fed Funds Rate up from 0.125% to 0.375% last December it could be described as a 200% rate increase (since 0.375 is three-times 0.125). This means that by taking the percentage change of a percentage, or in this case by charting percentages using a log scale, it can be shown that last December’s rate hike was the most aggressive monetary tightening in the Fed’s history!

I suspect that Mr. Mauldin’s mistake was innocent, but a sure way to reduce the credibility of an otherwise good argument is to use flawed statistical methods to support it.