Farmers are caught in a developing cost squeeze. Global oil costs are threatening to balloon from about US$80 today to over US$100 per barrel, which would be a 25 per cent leap. On the other hand, interest rates in the U.S. and Canada are scheduled to decline by as much as 1.5 per cent by year-end.
But those facts are not the whole story. A jump in fuel costs would be immediate and visible at the fuel pump. The interest rate drop would be only at the front end of the yield curve that goes from overnight to 30 years. After that, it’s the market that makes the moves. The 30-days part of the curve is the only section that is directly under U.S. Fed control. The rest, out to 30 years, is controlled by the market.
What it costs to fill your fuel tank therefore depends not on the usual business cycle, which would predict that a slowdown in gross domestic product (GDP) growth would induce the Bank of Canada and the Fed to cut rates. Today, fuel prices are heavily determined by missiles over the Middle East and what will inevitably be not so much stimulative as compensatory moves by central banks. In our case, that’s the Bank of Canada and the Federal Reserve Board in Washington. (Editor’s note: This column was written before the Bank of Canada’s Oct. 23 announcement cutting its target for the overnight rate to 3.75 per cent as well as the U.S. Fed’s Nov. 7 announcement cutting its own overnight rate range to 4.5-4.75 per cent.)
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The present Middle East war, though horrible on the ground and for its many victims, has been kind to energy producers. But the war is growing, as Israel responds to the launch by Iran of about 200 ballistic missiles earlier this month toward Israel-based targets and also expands its military operations in Lebanon.
In the first week of October, oil prices rose by 10 per cent, to about US$78 per barrel. That would be just the beginning, for in 2022 when war broke out in Ukraine, oil prices zoomed to over US$100 per barrel. In the present situation, benchmark Brent crude, recently at US$81 per barrel, could soar. Though the U.S. is the world’s biggest oil producer, active oil prices depend on Middle East operations such as the Abadan refinery in Iran. It’s a target. Israel could strike it or the oil fields or terminals in the Persian Gulf, hitting refineries there and knocking a few per cent out of world daily oil shipments. There could be naval actions in the Persian Gulf that could restrict supply enough to make oil rise to US$130 per barrel, according to The Economist, a British publication.
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The Fed and other central banks would not stand by. Chances are they would try to support business and consumers by reducing interest rates. There are as many forecasts for rate moves, even without wartime compensation, as there are banks and macroeconomists.
ING, a very large bank headquartered in the Netherlands, has predicted a fall in overnight rates to three per cent. Fitch, a credit rating service, has predicted a slow easing of rates to compensate for flowing growth of GDP in the U.S. as global gross domestic product falls from 2.5 per cent in the third quarter of 2024 to 1.6 per cent in the first few months of 2025. European markets expect cuts, surveys say. Same goes for China.
Cuts on the short end of the yield would help straighten out the yield curve which, recently, has posted lower rates in the two- to five-year space than rates for a few months. The distinguished monetary economist Tom Czitron, who writes for the Globe and Mail, makes the case that the Bank of Canada should cut rates to compensate for what has been declining real income for Canadian families.
What a ramp-up of energy prices will mean for interest rate forecasts has to be compared to the effects of US$100+ oil.
First, it has to be noted, interest rates are very democratic. They hit everybody, though in different ways, depending on where you are on the machinery lot. Lenders can charge more but they wind up lending less to business and farmers. Farmers and most businesses wind up paying more for loans and doing less business. To offset rising financing costs and higher consumer prices, central banks will lower interest rates aggressively, as they did, for example, in 2008.
The word on your bonds
Farmers, like everybody else, have to abide bouts of cost-driven inflation, but the prospect of interest rates pushed down by central banks opens the path to bond speculation. As interest rates fall, the prices of existing bonds with fixed coupons will rise. Riskless government bonds generate the largest gains in this process while riskier bonds, especially junk, can reflect the problem of selling enough goods to generate money to pay bond coupons and to redeem them when due.
Mortgage costs can drop with falling interest rates, but terms of bonds are carefully shepherded by lenders, lest they be caught out getting insufficient interest when they have to roll or refinance the money they have lent.
For farmers, oil-driven inflation could lead to higher earnings if central banks cut rates in 2025 with a one per cent drop and a further drop of 50 basis points in 2026 — a frequent forecast in the financial press. Core inflation of about 2.6 per cent in late 2024 could drop to 2.2 per cent or even two per cent for 2025. These are leading U.S. rates that the Bank of Canada would follow, if not match. The “coulds” and “mights” depend on Middle East conflicts.
The bottom line is that conflict can lead to higher fuel costs which, in turn, boost crop costs and market prices. Arbitraging fuel and crop prices will help or harm Prairie farmers who sell grains into a troubled world market.
