Commodities

An unintended consequence of the Fed’s massive injection of liquidity has been to create bubbles in commodities. At least that is what an increasing number of economic commentators are concluding.

Bernanke and his co-believers are equally oblivious to asset market inflations. From emerging markets to precious metals to agriculture, it’s like déjà vu all over again. Nascent bubbles are emerging. But to what Havensteinian conclusion does the warped logic of our central bankers lead them? Why, the world needs more liquidity of course!  (Dylan Grice, Societe Generale 22 Oct 2010)

Speculative excess has dominated commodity markets these last few years.  By developing technologies to allow computer based traders easier access to exchanges, and by launching retail commodity funds, the floodgates to a huge wave of speculative capital were opened.  The result is that computer based traders have become a dominant force in some markets.  And because these algorithmic traders are trading on technical signals instead of fundamentals – and speculative funds outweigh the actual demand for oil, metals, grain etc in the real world – commodity prices are diverging from their true and fair price for long periods of time.

With commodity prices set by money flows as they now are, commodity fund managers have a vested interest to hype the latest story – whether it be ‘peak’ oil, or gold’s usefulness as a hedge against inflation – to keep these funds afloat.  Long after the bubble burst in 2008, fund managers are still trying to scare us with the scarcity that will caused by the ending of China’s age of self sufficiency.  True, Chinese stockpiling has helped to underpin demand during the last couple of years, but the weak correlation between actual supply and demand and prices is because something else is really going on.

One of the biggest selling points to investing in commodity funds to start with was that they could be used to hedge risk in portfolios of stocks and bonds – given the historically low correlation between commodities and stocks.  Unfortunately, because fundamentals no longer drive commodity markets, commodity prices and stock prices have become increasingly correlated – the common denominator simply being the general appetite for risk.

It’s hard to understand, after all, why oil prices should remain at higher levels now than they were in 2007, as the worst global recession in seventy years shows every sign of deepening and demand for oil is falling.

In fact the increasing correlation between oil and stocks is part of the same black box trading phenomenon that helped to make supposed ‘tail risk’ the most likely risk.  Instead of becoming a passing trend the linkage has become even stronger, now that investors are increasingly accessing the market through ETF funds.

In effect this is an industry exploiting the ignorance of retail investors to rig the prices of commodities sold to manufacturers and consumers in the real world – a sort of tax on stupidity if you will.

The distorted prices on the commodity exchanges could be contained if only Congress restricted the participation of computer-based traders – which because of the flash crash they may now begin to do. At least the CFTC and the European financial regulator are introducing new rules to begin to eliminate speculation from the markets.

Investors who continue to bet on elevated commodity prices stand to lose a lot, therefore, should these funds fall out of fashion.  It would be extremely ironic if the price of oil and other commodities collapsed because of technical patterns in the charts. For a classic head and shoulders pattern is now forming, ominously, in the copper and crude oil markets.

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