Volatile commodities

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By Cees Bruggemans

For years commodity prices have risen explosively, driven by strong real sector demand and constrained supply. Increasingly, financial speculation has joined the fry.

Where is this leading?

At what point will commodities overreach, entering freefall? Have we in fact reached such a cyclical tipping point at Easter 2008? Or is peaking still down the road?

These questions don’t query the nature of the long-term commodity fundamentals.

Global growth will be aggressive for decades still, with critical mass increasingly shifting towards developing emerging countries. These enjoy high rates of catch-up growth, whose early stage of industralisation is typically commodity-intensive and –inefficient.

Also, the easy commodity deposits have been mined, mining ownership has been consolidated and governments are increasingly practising resource nationalism, keeping new supply tight.

All these features taken together support elevated commodity prices longer term. But there are likely to be short-term deviations.

With commodity prices acquiring strong upward momentum in recent years, they increasingly attracted attention, pulling in growing numbers of financial speculators.

When US financial troubles erupted in mid-2007, mobilizing the Fed into aggressive policy interventions, including interest rate cuts also undermining the Dollar, a major additional reason was created for financial migration into commodities. Excess liquidity at reduced carrying costs invited increased commodity speculation.

With US financial troubles far from finished, and other parts of the world (Europe) still to be drawn in more fully, there is probably more downside to interest rates and Dollar ahead, and consequently more potential for commodity price gains.

But only until the tide turns, after which sharp commodity price corrections may be expected following the bubble-like gains of recent times.

The fundamental reason for a turn in commodity prices would be that growth is slowing in the West, that the East will probably as a consequence also import some of this weakness via trade channels, and that rising commodity prices are globally eroding consumer purchasing power, inviting yet more weakness.

Classically, at some point this will slow commodity demand growth enough to be overtaken by supply, causing inventories to start rising. This is already happening in oil and may spread shortly to more metals and minerals.

What has so far prevented this budding underlying shift in the fundamentals to check commodity prices is the financial speculative overlay. With US troubles far from being at an end, with more policy aggression and market anxiety likely still ahead, further lowering interest rates and Dollar, the attractiveness of investing in commodities has yet to falter decisively.

Unless, and until, the US financial troubles intensify to a point where anxiety and risk aversion suddenly greatly deepen, and the expectation of more pronounced growth interruption brings forward the future tipping point in basic demand/supply, abruptly changing expectations about the commodity outlook for the worse, inviting profits to be taken, rupturing the upside price drive.

There was abrupt deepening of US market anxiety prior to Easter 2008 as US banking problems looked increasingly intractable, and the ultimate outcome direr than ever.

The Fed redoubled its lifeboat actions in March by widening access to its liquidity, again aggressively cutting interest rates and facilitating bank mergers, yet none of it apparently being enough to solve the mounting liquidity and solvency problems at US banks.

The perceived inevitability of America sliding into recession has further heightened market anxieties.

Despite the prolonged playout to financial troubles still to come, has an early tipping point been reached, unnerving commodity speculators? Or are the abrupt sell-offs only temporary setbacks, reflecting temporary loss of nerve rather than heralding end of commodity binging?

Rising commodity prices fuel our inflation, creating major problems for the SARB. Commodity price fatigue would be most welcome, inviting oil price retreat, possibly also arresting the agricultural price bubble, although probably not preventing more Rand weakness.

We should welcome an end to excessive commodity price gains, especially oil. This would assist in undoing our inflation bubble, lessening upward pressure on interest rates. It could even free up space for rate easing, given our growth loss to date, provided the Rand doesn’t weaken excessively.

Source: Cees Bruggemans, Chief Economist, FNB, March 25, 2008.

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