Commodity Prices have been on a tear. No question about it. Gold has traded over $1,300 per ounce and silver is over $21 an ounce. The grain markets have seen huge gains in corn, beans, rice and oats. Even markets like coffee, orange juice and cotton have participated in the broad commodity rally. Does this mean it’s a good time to put more money in commodities? Not necessarily. This is where our philosophy diverges from stockbrokers. We don’t generate revenues for the firm based on equity under management. Therefore, our best business practice is to provide our individual traders with information that will help them be successful over the long term.
The commodity markets as a whole, have built this rally on the economically sound principals of inflation, which include a declining dollar and low interest rates. However, according to the data that I’ve been watching, it’s quite possible that we’ve gotten a bit ahead of ourselves in the economic cycle. At this point, the anticipation may be greater than the event.
Starting with the big picture. There is a third component to inflation that hasn’t gotten much press over the last year and that is, velocity. Velocity in economics is how quickly money is changing hands. The higher the velocity of a dollar and the more it circulates, the more action there is in the economy and the closer we are to potential inflation. What we’ve seen since the economic crisis began and the housing bubble collapsed is that the Federal Reserve Board has flooded the economic system with Dollars.
The adjusted monetary base of the United States has increased nearly 25% since September of 2008. Broadly speaking, this means there are 25% more dollars in our pockets and in our checking, savings and cd accounts at the bank. However, as I wrote last week, Americans are finally starting to save their money. This is why the velocity of money has declined by more than 17% since the economic crisis began in 2008. This is in spite of the Federal Reserve Boards attempts to stimulate spending.
The United States is the financial trading center of the world. We have the most mature stock and commodity exchanges. They are the most highly regulated and also the most liquid. Therefore, we are the hub of the global financial network. The commodity markets here in the U.S. service 40% of all traded commodities. Therefore, the prices of commodities traded here in the U.S. actually reflect a global view of fair value. The decline in the U.S. Dollar has made trading prices in the U.S. seem like the latest sale at Kroger, just bring in your Treasury coupon for double points.
Finally, in the weekly Commitments of Traders Reports, we have seen a very large build up of large speculator and commodity index trader long positions with the commercial traders increasing their short positions as the markets have climbed. The fact that many of these markets are significantly below their pre financial market collapse highs of early 2008 is a telltale sign that the current market rallies may be over extended. It’s important to note that the two groups supporting the commodity markets have no ties to fundamental value. The large traders are simply trend followers. They are willing to be long or short any market at any time. The commodity index traders are only allowed to purchase commodity contracts to keep their portfolios properly weighted. They will add positions as the market climbs and offset positions as needed on a market decline.
Commercial traders are the producers or, end line consumers of the actual commodities themselves. They are keyed into the entire production mechanism and have a keen understanding of the issues affecting their markets. The general theme I see building is that they believe many of these markets are substantially overbought and inflation is further away than we think. While they do believe there is inflation coming down the pipeline, they believe it is further off than the commodity markets are making it look. They have bought up large positions in short term Treasuries while taking a decidedly more bearish tone towards the long end of the yield curve. In fact, the commercial trader net position in the 30 year bond is the most bearish it’s been since 2005, prompting me to consider taking profits in our bond trade from several weeks ago.
The combination of an economy flooded with cash led many investors to anticipate inflation down the road, which makes commodities a very sensible place to put money. However, given America’s newfound desire to save, the flood of cash hasn’t quite had the textbook multiplier effect that was expected to increase GDP 50% for every dollar spent by the government. Given the over extended state of some markets combined with fundamental data supporting declining velocity, it may be a good time to adjust risk in the commodity markets. Velocity will increase and repurchasing commodities on a pullback could be an effective strategy once the actual race finally gets going.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.