How Interest Rates Affect Commodities And Indices

Interest rates reach equity indices through the discount rate applied to future company earnings and through the cost of corporate borrowing. They reach commodities through the opportunity cost of holding something that pays no income, through the currency the commodity is quoted in, and through the cost of financing inventory. Same policy decision, three or four separate transmission channels, which is why a rate rise can hit a technology index hard and leave copper untouched.

2022: rates up 425 basis points, the Nasdaq down a third

The clearest recent demonstration ran over a single calendar year. Through 2022 the US federal funds target moved from near zero to roughly 4.25% to 4.50%. Over the same year the Nasdaq 100 fell about 33%, the S&P 500 fell about 19%, and gold finished roughly where it started, down a fraction of a percent.

Three very different outcomes from one policy cycle. The technology index fell hardest because its valuation leans most on distant cash flows. The broad index fell less because a large part of it is companies earning money now. Gold, which the textbook says should have fallen as real yields surged, went nowhere, because central bank buying and a flight to safety offset the yield headwind. The textbook channel was real and it was not the only thing happening.

Discounting: why two points of rate takes 17% off a distant cash flow

The arithmetic behind the index reaction is a single formula. A cash flow arriving in ten years is worth its size divided by one plus the discount rate, raised to the tenth power. At a 3% discount rate, 100 USD in ten years is worth 74.40 USD today. At 5%, the same 100 USD is worth 61.40 USD. That is a 17.5% fall in present value with no change whatsoever to the business.

Now apply that unevenly. A utility earning steady cash today has most of its value in the near years, where discounting barely bites: 100 USD arriving next year falls from 97.10 to 95.20, a 1.9% haircut. A growth company whose value sits mostly a decade out takes the full 17.5%. That difference, repeated across hundreds of constituents, is what separates a technology index's drawdown from a broad index's in a tightening cycle.

There is a second, slower channel. Higher rates raise the cost of refinancing corporate debt, which shows up in earnings over the following year or two rather than on the announcement day. Highly leveraged and smaller companies feel it most.

Gold answers to real yields, copper answers to growth

Commodities do not share one rate channel. Split them by what drives demand.

• Precious metals pay no coupon, so holding them costs the real interest rate, which is the nominal yield minus expected inflation. Rising real yields raise that cost. The inflation half of that subtraction is what catches people out: rising prices help gold only while nominal yields lag them, and a central bank moving faster than inflation expectations turns the same inflation story into a headwind.
• Industrial metals and energy respond mainly to expected activity. Rates matter to them because tighter policy slows construction and manufacturing, but the link runs through growth expectations rather than through carry.
• Everything priced in dollars inherits a currency channel. Higher US rates relative to elsewhere tend to strengthen the dollar, which makes dollar-priced commodities more expensive for buyers holding other currencies, and demand adjusts.
• Inventory financing is the quiet one. Storing physical commodities is funded, so higher rates raise the cost of carry, steepen futures curves and discourage stockpiling.