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Written by Brad Zigler  |

December 09, 2010

Deciphering The Inflation Scorecard: Part 2

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The inflation scorecard isn't just about gold. In this installment, we look at the role of interest rates.

Earlier this week, in Part 1 of "Deciphering The Inflation Scorecard," we dug into some of the gold-based metrics used in each Friday's edition of Brad's Desktop to gauge the strength of monetary inflation.

In today's Part 2, we'll examine the interest-rate indicators used in the column and wrap up by creating a matrix that can be customized to derive the week's overall inflation "grade."

So, without further ado, let's get crackin'.

TED Spreads: Originally, "TED" was an acronym for "Treasury bill/eurodollar" and referred to the price differential between 91-day T-bill futures and eurodollar futures traded on the Chicago Mercantile Exchange. Eurodollars are U.S. dollars on deposit in foreign branches of American banks. T-bill futures are now extinct, so the TED spread now reflects the interest rate differential between cash bills and the dollar-denominated London Interbank Offered Rate (Libor).

The TED spread measures counterparty risk and is an analog of the gold lease rate. There's typically a direct relationship between the two rates. As explained in Part 1, the lease rate is the cost of holding physical gold in lieu of a futures contract. Investors are generally willing to pay more to hold physical gold when counterparty risk is high. Perceptions of greater financial risk thus increase the monetary demand for gold. This increased demand means physical (spot) gold is likely to be bid up.

COMEX Futures-Implied Finance Rates: Like the markets for other storable commodities, there are carrying costs embedded in the gold futures term structure. One of the components of the spread between delivery months is the cost of financing the gold inventory. Gold spreads, in fact, are often used as interest rate proxies by professional traders. When higher short-term rates are anticipated, long forward/short nearby ("bear") spreads are favored; when short rates are expected to decline, professionals will "bull" spread by buying nearby contracts against the sale of forward deliveries.

The degree to which futures-implied rates vary from Treasury yields is also predictive. Presently, 12-month futures finance rates are below those of one-year Treasurys, but the discount has been shrinking. This indicates the market's anticipation of higher rates in the future.

COMEX Futures-Implied Finance Rates

Long Bond Rates and the Yield Curve: The shape of the Treasury yield curve often reveals market expectations for the economy and inflation. The curve we quote is that spanned from three-month bills to 30-year bonds. Generally, a positive slope—higher yields for longer maturities—reflects investor expectations for future economic growth and/or greater inflation. Steepening and flattening of the curve reflects week-to-week changes in these expectations. An inverted curve—one characterized by a negative slope where shorter maturities yield more than longer-dated paper—bespeaks recessionary expectations.

Euro/Dollar Cross Rates: The value of the U.S. currency relative to the world's second reserve asset, the euro, is tracked to illustrate the greenback's strength in the interbank market. A weaker dollar may make U.S. goods more attractive to foreign buyers, improving the market for American exports, but can ultimately be inflationary.

The euro is the single-most important currency opposite the dollar because of its dominant position in the U.S. Dollar Index, its weighting in the IMF's special drawing rights and in the calculation of our proprietary Monetary Inflation Index.