Commodity-Price Bubble
The Financial World Gets Weirder And Weirder
By blackhedd Posted in bubbles | Commodities | deflation | Economy | inflation — Comments (27) / Email this page » / Leave a comment »
Of all the tangled and intertwined threads of the global financial crisis, a few have managed to capture the attention of the media and of people at large. Collapsing home values, of course. More surprisingly, the arcane and technical collapse of the Bear Stearns Companies, and the aggressive response by the Federal Reserve, which was called a “bailout” so many times that people now believe it was one.
And then there’s commodity-price inflation, which is a global phenomenon with many contributing factors. Most people don’t notice the prices of gold, silver, dry-bulk cargo holds, concrete, nickel, copper and scrap steel. But they certainly do notice gasoline, jet fuel, rice, milk, wheat, corn and cooking oil.
In a further display of how interrelated everything has become, commodity prices, already facing upward pressure from fundamentals (increased demand from Asia coupled with supply disruptions), have gotten caught up in the mess affecting the credit markets.
As a result, I now believe that many commodities are experiencing a price bubble, much like the stock-market bubble of 1999-2000 and the housing bubble of 2004-2006.
Price bubbles are inherently unstable, which means they always bust. They’re also inherently insane, which means they can go a lot farther before they do bust.
Where is the financial (i.e., the non-fundamental) pressure on commodity prices coming from? Let’s unpack it a little.
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The key factor driving the ongoing financial crisis is the unwinding of leverage. For a few years ending in mid-2007, it was standard practice to borrow enormous amounts of money on highly-liquid and globalized money markets, and use the proceeds to buy medium-term debt securities.
And this made sense. If you could borrow thirty times your capital at very low interest rates, and invest it in a delta-neutral trade that earned no more than one percentage point, you would have made a thirty percent return on your money before interest costs.
Of course, if the trade went against you and lost three percent, you’d lose every penny you started with. But long before you came anywhere near to that point, your short-term lenders would call you up and ever-so-politely tell you to either put up more cash, or liquidate. And by the way, you’d have until the end of the day to do so.
That’s how a lot of financial assets like mortgage-backed securities suddenly got dropped onto the market. And as their value falls, the margin calls keep coming, and soon even financially-healthy players are under distress. And they start selling completely unrelated asset classes, like stocks, to meet their cash requirements. That happened during the 1998 Long-Term crisis, and it happened last summer.
How does this affect commodity prices?
Because all the money that is flowing out of leveraged investments around the world has to go someplace, at least until the dust settles. The natural destination for it is the US Treasury debt market, particularly the shorter maturities.
But a funny thing happened there. Back in September, the Federal Reserve started aggressively cutting policy interest rates as it attempted to stem the rolling series of credit-market crises that started in August.
All of a sudden, the dollar started accelerating its fall (a trend which was already in place), and short-term Treasury debt started getting incredibly expensive.
That’s when the stampede into real (non-financial) assets like commodities got started. I remember writing here about the inverse linkage between the price of crude oil and the dollar, starting back in October. (Gold, which is a far smaller commodity than crude oil, joined the party about three weeks later.)
So far, this isn’t an unconventional analysis. But where do we go from here?
I think the dollar weakness is unsustainable, and will slow down as the Fed nears the end of its cycle of interest-rate cuts.
There has been a lot of debate about whether the Fed pushed too hard on the interest-rate lever, even as their wide range of other policy responses has had beneficial effects. As a result, there is a lot of inflation fear out there.
Ben Bernanke is keeping his game-face on about the inflation risk that he’s creating. And from mid-March to early April, the New York Fed took a series of quiet but unusual steps to permanently reduce the money supply. Bernanke fears a repeat of the Great Depression more than a return to Carter-era inflation, but he’s not ignoring the latter possibility either.
Going beyond all that, it just doesn’t make sense for global investors to be parking so much money into commodities and euro-denominated bonds. These asset classes can’t generate the rates of return that investors ultimately must demand. That means that both commodities and the euro are in a bubble, and it will have to bust.
So we could see crude oil back down to $80/barrel and gold at $700/ounce soon enough. Of course, before it crashes, oil could easily go to $150 or $180. As I said, bubbles are insane.
Where the de-leveraging cycle ends up is a much tougher guess. There are lots of home mortgages out there that were purchased with borrowed money, and someone has to end up owning them. At the moment, much of this paper has landed on bank balance sheets, where it pushes down capital ratios. That makes banks call in existing loans and keeps them from writing new business. (This is the proximate cause of the economic slowdown we’re now in.)
If there is no government policy response, this mortgage debt will necessarily deflate (fall in price) until it makes sense for investors to buy it with real money (cash) rather than with leverage.
That’s a bad place, and we don’t want to go there. The last time anything like that happened was in the early Thirties.
-Francis Cianfrocca (“blackhedd”)
Commodity-Price Bubble 27 Comments (0 topical, 27 editorial, 0 hidden) Post a comment »
OIH or USO, but be careful - the market can stay irrational much longer than you can stay solvent. Oil isn't going back under $100 (except for a spike) - at least not this year.
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"Enlightened statesmen will not always be at the helm." -- James Madison
the oil market in the end. It's just not a market I understand well enough to get into. (I looked at Forex and came to the same conclusion.)
And yes, I totally agree with your caution. All markets can stay irrational longer than you can stay solvent. It's a warning to keep in mind whenever trying to take advantage of market irrationality.
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You're not the only one who is having the same thought, and that makes almost every kind of trade very expensive.
I scaled back my own trading sharply when the crises started and basically went into capital-preservation mode. I usually look for volatility arbs, but these days even what looks like sharply overpriced volatility can easily turn out to actually be underpriced.
Most people don’t notice the prices of gold, silver, dry-bulk cargo holds, concrete, nickel, copper and scrap steel. But they certainly do notice gasoline, jet fuel, rice, milk, wheat, corn and cooking oil.
One of the hardest hit sectors is apparently the organic food market, where milk prices are hitting $7.00 a gallon. From the New York Times yesterday:
Rising prices for organic groceries are prompting some consumers to question their devotion to food produced without pesticides, chemical fertilizers or antibiotics. In some parts of the country, a loaf of organic bread can cost $4.50, a pound of pasta has hit $3, and organic milk is closing in on $7 a gallon.
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“Man, $6.99 for a gallon of milk is pushing it,” he said. “We have to be very careful about not pricing organics out of the market.”
Such is the mentality of the organic foods demographic, however, that some people are willing to sacrifice a lot even if the prices continue to rise:
At the Mississippi Market Natural Foods Co-op in St. Paul, Shaun Hainey, 26, said he had quit smoking and cut back on drinking and “superfluous recreational spending, like going skiing.” But he and his wife, Cassandra Hainey, have not cut back on organic food.
“We don’t foresee a price level at which we’d stop shopping organic,” he said.
[snark]Ok, so they won't drink, they won't smoke, and they're going to stop spending money on recreational activities so that they can continue eating overpriced bread and $7.00 a gallon milk. Call a divorce lawyer![/snark]
That here in Western Massachusetts, where there are a lot of organic farmers and still some conventional, family-run dairies and smaller farms, many of the convenience stores will give you a dozen eggs if you buy a gallon of milk for $2 or $3. But you cannot tell people who believe they're being poisoned by milk hormones that spending $10 or more on the organic equivalent is a waste of money.
Quote from their front page: "There's a new plot underway to sterilize your food and destroy the nutritional value of fresh produce."
Oh yes, and then there's that NAU stuff, too.
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...is a subject that goes back well before the start of the current crisis. You can find a lot of well-informed commentary on it on the web.
It's not news that the Chinese have stopped participating in our Treasury auctions. It's also not news that they've been crowding into euro-denominated debt (their trade deficit with the Euro-zone is considerably worse than it is with us, because renminbi has been falling against the euro even as it rises against the dollar.
Something's got to give. Europe is facing wicked inflationary pressures, and the last thing you want to own is long-term debt denominated in an inflating currency.
They've got huge demographic problems due to the negative or near negative population growth in most countries, coupled with a difficult time dealing with immigration. They continue to lag not only the developing world but also the US in terms of productivity growth, due to the heavy socialization of their economies and the prevailing "work to live, don't live to work" philosophy. Their banking sector is more balkanized and inefficient than most people realize, and they have unpopped housing bubbles in the UK, Ireland and Spain that even Miamians would blush at.
None of this bodes well for the Euro over the long haul, because a currency's strength ultimately depends on the strength of the underlying economy.
At the same time, they generally keep their governmental budgets in balance compared to us, and interest rates are only going to go up over the next couple of years because the central bankers over there seem to fear inflation more than recession. That makes me think that we are not going to see a decline in the Euro versus the dollar anytime real soon.
I can see the Euro getting to where the pound is now - $2 to a Euro, or so - before a correction has a chance to begin, especially if US policy makers continue to believe (wrongly, in my opinion) that devaluation of our currency will help us with long term competitiveness with regard to exports.
Over the longer haul, I don't see any of the remaining candidates for President addressing the long term structural, rather than monetary, issues with regard to the dollar, such as the deficit. I don't see Congress or the Fed having the backbone to accept any short term pain to reinstate discipline. With irresponsible fiscal policy as a likely long term factor, I'm not sure that their long term structural issues outweigh ours, and I'm not sure the dollar ever gets back to where it was in 2001 or 2002.
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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
...like the only country in Europe that really benefits from the euro is Germany. They seem to do well in the fiscally-disciplined, controlled-inflation world that the euro rules impose, while countries like Ireland, Italy, Spain and Greece are taking it on the chin. Even France would like to see lower euro interest rates.
From what I can see, Germany was flat on its back economically until just the last two or three years, and now they're doing pretty darned well.
Why is this ironic? Because the whole point of the European monetary union was to do what no one from Barbarossa to Napoleon to the World War alliances ever managed to do: construct a stable political order in Europe which kept Germany under control.
The only way to stop these bubbles is for the Federal Reserve to stop printing money. And the only way that can happen is if America stops living beyond its means, piling up huge debt at every level from credit cards all the way up to Treasuries.
Debt becomes monetized by the Fed; the excess money goes into one market after another; and those markets become manias and bubbles, one after another.
The U.S. is still the world's largest economy, and when we spend money (printed up in huge amounts by the Federal Government), the law of supply and demand says that prices of something have to rise somewhere.
Since 1995 or so, the money supply in the U.S. has expanded at an average annualized rate of at least 10%. After all the rhetoric about inflation, the fact is that the Federal Reserve has been expansionist more than it has been tightening, now for over 10 years. Whether the Federal budget was balanced or not.
And that excess money has to go somewhere. It keeps going into one market after another, bidding up prices in one market after another. Dot.com companies. Then real estate. And now commodities.
In the past, this would have leaked into the Consumer Price Index long before this, causing the Fed to tighten, reducing spending and limiting any more bubbles. But globalization has enabled U.S. businesses to deal with rising costs by outsourcing. This latest bubble in commodities is causing food and fuel prices to rise, but those are not reflected in the so-called "core rate" of inflation.
This makes U.S. inflation look lower than it really is, and that has given the Fed the excuse it needs to keep monetizing Federal spending. In the past, a worker would be losing purchasing power against inflation. Now that worker is losing purchasing power against cheap labor from overseas. But the effect is the same: Inflating makes us poorer.
Is it the Treasury (which spends money) or the Fed (which regulates its value) that is at fault? Or both, in which case you should stop blaming it all on the Fed?
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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
"I'm entirely to blame".
Except that it's not true regarding the world economy. We haven't been "printing money" and certainly we're not the only player nor the "first-cause" of global inflation.
This "one-size fits all explanation" for the every problem in the world (it's our fault) is both tiresome and arrogant. We don't have the power to magically solve the world's problems.
It's especially amusing when these analyses conflict: the global warming alarmists want the U.S. to flood the market with dollars, billions or even trillions more, on measures they believe (erroneously, but that's another discussion) will cure global warming, even though even the small measures to date (e.g. ethanol) are worsening world inflation.
You blame America firsters need to get on the same page.
It is hard to find an investment opportunity that is not overpriced. The stock market, if it goes like it has in prior recessions, stands to drop another ten to twenty percent. Real estate is still overpriced, in terms of asking price, because sellers are not yet ready to take their beating, and even if they move to today's market clearing price it's not clear how much worse the real estate market is going to get before we hit bottom. Bonds and T bills are yielding pathetic returns, and even there many presumably AAA bonds may have a hidden risk of turning into junk overnight. Developing economy stock markets have run up enormously - notwithstanding their recent declines - and it's wise to remember that even if their economies and currencies are going to prosper over the long haul, there is a lot of risk associated with trying to get money out of those kinds of investments (me, I'm glad I turned down the invitation to invest in a big farm in Argentina, even though the fundamentals are good, because those third world governments are unrivaled at finding ways to screw you.) Gold is at historic highs by some measures, and above the mean by any.
At my house, we are sitting on way too much cash right now, having sold most of our bank stocks last winter when things started looking soft. I just can't find a place to put the money that leaves me feeling secure I won't face nominal losses in addition to what is lost to inflation.
In that world, the Euro looks like a better bet than some of the alternatives, and if the third world economies are able to keep chugging away the fundamentals on commodity prices might catch up with the bubble effect and keep prices from crashing.
In other words, these two investment sectors may be overvalued because, as overvalued as they are, for the near to intermediate term they look pretty good compared to the alternatives.
If you have some great ideas on where to put money that looks better than T bills or gambling that the dollar has not hit bottom versus the Euro, I'm eager to learn.
...but I agree that good risk-adjusted opportunities for dollar-based investors are very hard to come by in this environment.
I am quite convinced that debt deflation is now a reality, because current yields on risk-bearing debt are still too low for anyone to purchase without leverage. And there's no leverage available to buy debt where it is now because banks are undercapitalized.
Just about all of my own risk capital is now in non-public equity.
...the Internet bust. SOx came in 2002.
Stocks are the new bonds. Because of the ownership structure of public large-caps (mostly mutual funds and tax-free institutions), they have to deliver earnings consistency at the expense of high growth.
Outside of being the one person in a hundred who can pick stocks better than a dartboard, it seems to me that the best way to make money in stocks is to sell gamma to the rest of the market.
Only problem with that strategy is that the market crashes from time to time.
That is why I am searching for a small biz idea. Time to get off the couch and do some hands on work creating value, rather than managing my money.
Ask not what I can do for my country, ask what my country can do for me. Washington Elected Elite
Always quality posts BH, thanks!
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Buyers and sellers don't necessarily have to use the "market" price for oil exchange.
With decreasing demand and increasing supply that the price should come down, but the bubble boys are keeping that from happening. That leaves sellers with unsold product who want to unload it... and they can if they lower price. The question is if this can happen enough to essentially "break" the oil market when the price is pretty much ignored by a major portion of the market.
power amplified by incredible speculative steroid injections from Wall Street, inflated further by a falling dollar being heavy-massaged by the Fed. When this bubble bursts, it will be a doozy!
investors in general. The Treasury and FED both seem content to let the dollar "float" (lower). At least UK has started to raise rates, so that may start to help the dollar and
T-Notes/Bills
Last I heard they (BOE) were accepting a wider assortment of debt, and they did just lower by a quarter point this month. Are you sure? You think the Euro is crazy relative to the USD, check out the British Pound trashing, the charts show a parabolic rate of ascent, thanks the BOE lowering rates, while the Eurozone is on hold.
Is there a long term put contract on oil that can be bought by an ordinary person without huge amounts of dollars?
If this really is a bubble, a leap like put option on oil might be a good play. I wouldn't want to go any shorter than a year, 2 would be better. As you say, there's no telling how long a bubble will inflate before it bursts.
Actually, I usually don't play on the short side of markets and my dealings with puts it as a writer rather than a buyer (and got bit by a few in the last few months). I probably wouldn't jump in right away, but if oil hits $150 or so it would be hard to resist.
By the way, your last 2 sentences are downright scary... but do you really think it'll go that way if the government stays out? What scares ME about the current housing situation is that government is talking about FORCING mortgage lenders to eat part of the price decline of houses they hold mortgages for. If they do this, they'll cause an immediate stop on new mortgages with anything less than 80% loan to value, which will lead to further home value drops, which will lead to more write downs and could spiral out of control from there.
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.