Would you like anything else with that coffee, Ben?

Last week we received some new data linking commodity prices to the decisions of the U.S. Federal Reserve.

I have long argued that the broad increase in commodity prices over the last five years has primarily been driven by strong global demand. But I am equally persuaded that the phenomenal increase ([1],
[2]) in the price of virtually every storable commodity in January and February cannot be due to those same forces. This was a period when the economic news was getting bleaker by the day, eventually persuading many of us that a recession has likely started. To argue that January and February’s news instead signaled booming commodity demand strains credulity.

Nor do I agree with those who attribute the recent commodity price increases primarily to the falling value of the dollar. True, the dollar price of an internationally traded commodity should rise when the dollar falls. But the dollar only depreciated 7% against the euro between January 1 and March 17, while the average commodity included in the table at the right gained more than twice that. You paid more for your aluminum and coffee and wheat regardless of whether you tried to pay with dollars or euros or yen.


Percent changes in commodity prices (from DRI/Webstract), exchange rate (from FRED), and expected fed funds rate (from CBOT via TFC)
Jan 1- Mar 17 Mar 17 – Mar 20

aluminum +21.9 -3.6

barley +7.4 0.0

cocoa +25.9 -14.2

coffee +14.7 -12.0

copper +21.7 -2.7

corn +14.1 -5.0

cotton +7.3 -6.3

gold +21.7 -10.7

lead +11.3 -7.8

oats +14.4 -9.3

silver +36.4 -15.8

tin +24.1 -3.7

wheat +32.7 -13.2

zinc +3.7 -8.1

commodity average +18.4 -8.0

$ per euro +7.0 -2.2

April fed funds -1.91 +0.22

Instead I believe that Harvard Professor Jeff Frankel has the correct explanation– commodity prices at the moment are being driven by interest rates, with a strongly negative real interest rate increasing the incentives for speculation in any storable commodity.

A simple efficient markets view suggests that the price of a storable commodity on any given day already incorporates expectations of foreseeable future developments, in which case the change in price would be driven by unanticipated news. One of the biggest surprises of the new year was how quickly the Federal Reserve lowered interest rates. For example, on December 31, the CBOT fed funds futures contract implied an expected fed funds rate of 3.855% for the month of April. By March 17, that expected April rate had fallen to 1.945%, a phenomenal drop of 191 basis points within the space of less than three months. These revisions in expectations of Fed policy coincided quite precisely with the boom in commodity prices over that period.

However, at its March 18 meeting, the Fed surprised the markets, dropping its target for the fed funds rate by “only” 75 basis points, with dissents within the FOMC about whether they should even go that far. The market had expected a bigger cut, and the expected interest rate implied by the April fed funds futures contract shot back up on the news to 2.165%, a 22 basis point gain.

It’s interesting to note how dramatically commodity prices responded to the news that the April interest rate was going to be higher than markets had been anticipating. In the days since the FOMC meeting, the average commodity in the table above has fallen 8% in value.

I had urged even more restraint for the Fed at its March 18 meeting, in which case I have every confidence that the numbers in the table above would have been even more dramatic. Even so, it seems pretty hard to look at these data and conclude that the Federal Reserve has not been a major factor driving commodity prices over the last few months.

Why does it matter? Swings in relative prices of this magnitude are destabilizing. The Fed would like to stimulate more, but it also has to be realistic about what it is capable of accomplishing through manipulation of the fed funds target. Bernanke also needs to be mindful that one of his most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.



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34 thoughts on “Would you like anything else with that coffee, Ben?

  1. Charles

    James Hamilton says, “Bernanke also needs to be mindful that one of his most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.”
    Amen, James. I think that policy makers often get so caught up in the technical side that they lose a sense of the bigger picture.

  2. DickF

    Nor do I agree with those who attribute the recent commodity price increases primarily to the falling value of the dollar. True, the dollar price of an internationally traded commodity should rise when the dollar falls. But the dollar only depreciated 7% against the euro between January 1 and March 17, while the average commodity included in the table at the right gained more than twice that. You paid more for your aluminum and coffee and wheat regardless of whether you tried to pay with dollars or euros or yen.
    It is a mistake to assume that in an inflation all prices move relatively the same. In the initial phases of an inflation the debased currency will first impact raw materials, commodity prices, and factors of production. Commodity prices rise faster than general prices signaling that we are beginning an inflationary cycle.
    There is resistance to increasing prices in consumer goods at the beginning of the cycle because suppliers do not want to find themselves caught overpricing goods if the inflation does not materialize. But once the consumer side begins to react to inflation it is then that the increase in prices in these goods far outstrips the decline in the currency as inflationary expectations push prices up.
    There is no contradiction in commodity prices rising faster than the fall in the currency.

  3. Fullcarry

    How much confidence is there in the FED when the whole current account deficit is being funded by foreign central banks?

  4. Moe Gamble

    Commodity prices rose in sync (for this short period) because all of them were connected to problems with oil supply.
    There are serious supply/demand problems with oil, and they are getting worse.
    Because of the oil supply problem, corn is being converted to fuel (using natural gas), thereby driving up corn and natural gas prices.
    An increase in land devoted to corn drove up soybean and wheat prices.
    Shortages of energy in South Africa resulted in mine closures and drove up platinum and paladium prices.
    Goldbugs saw oil and grain prices going higher and bought up gold as a hedge.
    Bernanke’s interest rate play (0.75% instead of the 1% expected) worked for less than a week to contain commodity prices. Look at what’s been going on with grains the past couple of days with the funky weather. Check out today’s oil and gasoline inventory reports, and then check out prices. I’ve had three separate buy signals on oil since the bottom of this little correction.
    Bernanke won’t be able to contain commodity prices no matter what he does with interest rates, because the problem is supply.

  5. knzn

    “one of [Bernanke's] most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.”
    One could argue (and Paul Krugman might) that the exact opposite is true. If Bernanke wants to stimulate growth, he needs to get the real interest rate below the level that would be associated with zero growth. There is no a priori reason that that level might not be below, say, negative 2.5% (or the negative of whatever you think that the perceived target inflation rate is). Given the dramatic increase in the apparent price of risk, I would say that possibility is more plausible today than it has been at any point in my lifetime, at least. If it turns out to be the case, then the only way fed funds policy can be effective in stimulating growth is by getting the expected inflation rate above 2.5% (or whatever is the currently perceived target). In other words, under that circumstance, confidence in the Fed’s inflation-fighting resolve becomes one of its greatest liabilities.

  6. mike

    Another possibility is that market speculators were slow to realize how inelastic demand is for many of these commodities. That, combined with fundamentals noted by JDH and many others, has caused prices to increase sharply.
    See: http://online.wsj.com/article/SB120613138379155707.html
    I’m open to the idea that interest rates have been influential to price increases since January. This explanation requires that inventories rise with prices. So show me the inventories.
    Here are DOE inventory estimates for oil:
    http://tonto.eia.doe.gov/dnav/pet/pet_stoc_wstk_dcu_nus_w.htm
    If anything, inventories declined in the first quarter of 2008 relative to the last quarter of 2007. No buildup there.
    Maybe I’m missing something obvious here but I’d love to know what it is.
    -mike

  7. Charles

    knzn says, “One could argue (and Paul Krugman might) that the exact opposite is true. If Bernanke wants to stimulate growth, he needs to get the real interest rate below the level that would be associated with zero growth.”
    The trick of a really good Fed chief is to convince the public that he’s serious about fighting inflation while pumping money into the system. But once confidence in price stability is gone, stimulative policies backfire, generating more inflation and unproductive investment than growth can overcome.
    The 1970s are a very good object lesson. While the causes of that inflation were rooted in factors beyond the Fed’s control (oil prices, rise of Japanese/decline in American manufacturing, decline in Brand America), people started buying things not because they expected to produce something with them but to avoid declining currency values. Buying up raw land just to hold it is about the worst possible investment from a productivity standpoint. Buying a car today rather than shopping around because you’re afraid that tomorrow it will cost more adds to inflationary pressures.

  8. jg

    Glad to see that the Fed partially took you up on your request for an experiment, Professor, on what would happen to commodity prices if they cut less than expected.
    Your explanation makes sense. Eugene’s point is a good one, too, that there may be a second driver of commodity prices — speculators? — evidenced by the fall/winter run up in gold.

  9. me

    This from the FT today says metals is demand driven with no speculators involved or mention of interest rates.
    “Industrial demand behind boom for metals
    By Javier Blas in London
    Published: March 26 2008 02:00 | Last updated: March 26 2008 02:00
    As speculators and investors attract blame for driving up commodity costs, new research shows demand from industrial users has spurred a price boom in a range of metals.
    Prices of metals such as iron ore and cobalt that are bought and sold privately between producers and customers have risen faster than others such as copper that are traded on exchanges, says Lehman Brothers.
    The investment bank says this lends weight to the argument that supply and demand factors, rather than just financial flows, are behind the boom in prices.
    Its new index of non-exchange traded metals rose 598 per cent from January 2002 to early this year. During the same period, an index of exchange-traded metals rose 246 per cent.
    The diverging trend has gained pace in the past year, with non-exchange-traded metals rising 94 per cent and exchange-traded metals gaining 26 per cent.
    Michael Widmer of Lehman Brothers said speculators had difficulty gaining access to nonexchanged metals, meaning their price surge should reflect fundamentals more closely.
    “Keeping in mind the price gains in non-exchange-traded metals, we believe that the recent appreciation of base metals is not entirely driven by speculators . . . but by fundamentals,” said Mr Widmer.
    Metals and ores such as ferrochrome, cobalt molybdenum, magnesium, rhodium, hot-rolled steel, iron ore and alumina are traded over the counter between producers, physical traders and consumers.
    Financial speculators play a small role in those markets, although some banks, including Credit Suisse, have started small investing operations in non- exchanged metals such as cobalt.
    Mr Widmer said the fundamental market dynamics for many of the base metals, non-exchange and exchange-traded alike, had been similar. “A raft of supply disruptions and healthy demand, especially in China, meant that markets have remained tight.””
    http://www.ft.com/cms/s/0/9a27e2be-fad7-11dc-aa46-000077b07658.html

  10. Anarchus

    The problem I have with the logic of Frankel’s analysis is that he speaks of economic “weakness” as if that implies a dimunition of demand, which it does not.
    While it’s conceivable but as yet unknown whether or not economic growth in the U.S. has turned negative, even if economic growth has decelerated in the BRIC’s that still means increasing demand for industrial and agricultural stuff, which if demand is trying to increase faster than supply suggests upwards pressure on prices – which I think is the case with commodities such as copper, oil, fertilizers and lots of the grains.
    While the timeperiod analysis split between Jan 1 thru March 17 and March 17 thru March 20 is anecdotally interesting, it doesn’t prove anything to me. It is clear that for whatever reason, the major run in gold and other key commodities began in early August when the Fed initially began reacting aggressively to the credit crisis by cutting the discount rate and the exchange rate of the USD came under enormous pressure.
    If the negative real rate/storable inventory hypothesis is correct, wouldn’t you expect to see rising reported inventories of all these key commodities? And in fact from early August to present if anything commodity inventories have GONE DOWN and not up.
    I don’t have a great explanation myself other than to note that there’s a huge divergence between the aggressive easing of the U.S. Fed and the relative tightness of the EU central banking authority and that’s been killing the USD and will continue to kill the USD as long as the divergence is maintained. And IMHO while the USD declines precipitously the commodities are going to rise at an alarming rate and it has little to do with the cost of carrying inventories.

  11. pat

    Jim says: “The Fed would like to stimulate more, but it also has to be realistic about what it is capable of accomplishing through manipulation of the fed funds target.”
    Very good advice — I pray the FOMC will listen to it. While the Fed can make sure that short term interest rates are lower than neutral and thus providing a conducive environment for the recovery, they need to understand there is one crucial element of the recovery that is mostly not substitutable: time. The sub-prime mess will take time to clear, the overbuilding of housing stock will take time to depreciate and be realigned with the demand, the consumers will need time to change their mentality of spending every penny in the pockets and get into the habit of saving a little … an extremely low fed funds rate will not speedup any of these processes. If anything, it could potentially make the processes longer by taking away some of the incentives to do the necessary painful adjustments.

  12. Bruce Britton

    My sustainability-obsessed friends claim that the long term increases in commodity prices are due to our finally running out of them, as they have long been predicting. Is there any evidence for this, and if so, for what commodities?

  13. JDH

    RN, if I’d intended to say

    what a horrible investment gold is

    I would have said it this way:

    what a horrible investment gold is

    I think it should worry you a little if you often find it necessary to distort other people’s position in order to express your criticism of it. Among the statements I actually made in the 2005 post to which you refer was

    today’s Fed looks to me even more committed than Volcker was to preventing even the smallest whiff of inflation.

    You are right that the above statement is something I’ve changed my mind about since 2005, and indeed, this post is precisely about some of the facts that caused me to change my mind.

  14. Anarchus

    Bruce B, the two commodities that seem to be the most supply-constrained over the next 5 years from my perspective would be copper and crude oil.
    The next meaningful expansion of copper production has been hard to identify and even harder to bring on line – the $3.4 billion Oyu Tolgoi mine in Mongolia (a joint Rio Tinto & Ivanhoe project) keeps slipping its schedule and won’t begin production now until 2011 at the earliest. Other than that, there’s nothing more than dribs and drabs of new production in copper. In the meantime, China and India keep building out infrastructure and key power grid, potable water supply and telecom applications demand lots of copper. And the best substitute material for copper is silver (good luck with that!) or aluminum for certain limited applications. No help there.
    The peak oil story is well known here and requires no background – I would note that I had lunch with a very bullish Charlie Maxwell this week. Though he thinks the supply situation in 2008 and 2009 is pretty good because he has the Saudi’s bringing on an incremental 1.5 mbls/day of new light sweet production, the 2010 and beyond situation gets tighter and tighter and tighter as demand in China and Asia keeps growing.
    One odd mathematical fact that had us mystified is this: in the late 1970s and early 1980s, the nominal price of oil was $30-$45 per barrel but major oil companies were using a long-term price of $50-$100 per barrel in their capital budgeting decisions. And so they overinvested wildly. Today, the price of oil has gyrated between $75 and $105 for the past year, but the majors are still using $40-$60 oil in their capital budgeting decisions and so are substantially underinvesting. Against this backdrop, Exxon still has the world linearly increasing oil production at 1.2% per year annually out through 2030. It’s just nutty.

  15. PrefBlog

    March 26, 2008

    There’s a bit more colour on the Clear Channel deal today, which will of intense interest to those watching the BCE / Teachers deal:
    Banks financing the $19.5 billion buyout of Clear Channel Communications Inc. stand to lose about $3 billion on t…

  16. mike

    Anarchus,
    Interesting.
    I don’t know minerals as well as agricultural products. But agricultural products also look extremely supply constrained in upcoming years.
    In the late 70s and early 80s it looked like prices would continue to increase, perhaps at the rate of interest or more, as the simple economic model predicts. So that may have been a reasonable projection.
    Today I think everyone is more skeptical about real supply constraints of commodities. For well over a hundred years, those apparent constraints have always vanished–a new deposit discovery, a new extraction technique, fewer large-scale embargoes, and in agriculture, sustained worldwide yield growth that was just amazing (thank Norman Borlaug, not the innovating efforts of all the world’s farmers).
    But today I think the agronomic/mineral sciences are better understood. And demand growth is truly unprecedented, even as population growth slows, thanks to economic growth in China and India. So, yes, the projections seem a little nutty, but it kind of makes sense if you follow the history.
    Besides, why expect the majors to be better forecasters than the market? Futures markets for commodities one, two, or three years out, at least the ones I’ve looked at, appear to fluctuate almost as much as current prices. The seem to indicate very slight reversion to the historical mean, but not much. This indicates that markets are extremely uncertain about the long-run future.
    The oil majors are probably just being conservative since they were probably burned by over investing in the past. I wonder why they don’t increase capital investment and hedge that investment by selling commodities short on the futures market?
    On inventories: You’re right, I think. Without a buildup of inventories it’s hard to call the commodity price boom a bubble, or linked to interest rates and Fed policy. I keep asking that question…. oh well.

  17. mike

    Anarchus,
    Interesting.
    I don’t know minerals as well as agricultural products. But agricultural products also look extremely supply constrained in upcoming years.
    In the late 70s and early 80s it looked like prices would continue to increase, perhaps at the rate of interest or more, as the simple economic model predicts. So that may have been a reasonable projection.
    Today I think everyone is more skeptical about real supply constraints of commodities. For well over a hundred years, those apparent constraints have always vanished–a new deposit discovery, a new extraction technique, fewer large-scale embargoes, and in agriculture, sustained worldwide yield growth that was just amazing (thank Norman Borlaug, not the innovating efforts of all the world’s farmers).
    But today I think the agronomic/mineral sciences are better understood. And demand growth is truly unprecedented, even as population growth slows, thanks to economic growth in China and India. So, yes, the projections seem a little nutty, but it kind of makes sense if you follow the history.
    Besides, why expect the majors to be better forecasters than the market? Futures markets for commodities one, two, or three years out, at least the ones I’ve looked at, appear to fluctuate almost as much as current prices. The seem to indicate very slight reversion to the historical mean, but not much. This indicates that markets are extremely uncertain about the long-run future.
    The oil majors are probably just being conservative since they were probably burned by over investing in the past. I wonder why they don’t increase capital investment and hedge that investment by selling commodities short on the futures market?
    On inventories: You’re right, I think. Without a buildup of inventories it’s hard to call the commodity price boom a bubble, or linked to interest rates and Fed policy. I keep asking that question…. oh well.

  18. Anarchus

    Mike:
    We agree too on the ag complex, with a couple of caveats.
    Seems like forever that the U.S. had 360-400 million acres of productive farmland and the “problem” was getting people NOT to plant all of it so that grain prices didn’t collapse.
    Today, I’m told, the total plantable acreage has decline down into the 330 million acre range in the U.S. and last year we planted ALL of it – in fact, the 90+ acres planted in corn in 2007 was a record.
    Well, now for the caveats. 1. The ethanol mandates have been increased again and have again artificially increased demand for corn, 1a. Because ethanol mandates have started to grossly distort pricing of grains and have increased input costs for almost all grain and protein foodstuffs they may well be rolled back in the next couple of years, 1b. The U.S. currently also has import restrictions on foreign-”grown” ethanol which are likely to vanish in the next year, and 2. There is lots of extra land in Brazil for growing soybeans primarily – which the environmentalists consider rainforest and the potential farmers consider Pampa-like grasslands (I’m not going to get in the middle of this one – wouldn’t be prudent, not going to do it), but under many/most scenarios I’d expect more productive acreage to come on line in Brazil.

  19. JDH

    Mike and Anarchus:

    Unquestionably commodity fundamentals are the overriding factor if you look at the broad 5-year trend. However, these sorts of issues should be commodity-specific, and should produce big movements in the price of one commodity relative to another. But what I think is really striking is that over the last three months, the prices are all moving together. Moreover, the direction of the moves (prices going up as news of a weaker economy accumulates) is not what you’d expect with a fundamentals story, if your fundamental is anything other than the expected interest rate.

    As for inventories, it’s not that I’m ignoring that question. On the contrary, it’s such a good question, it deserves a really good response. I was originally intending to take it up in the current post, but it was getting too long and I was running out of time, so hopefully I’ll have another opportunity to discuss it. Among the issues I think deserve to be raised here are the quality of the inventory data, the various places in the production-to-consumption chain at which there’s a role for storage, and the precise details of the futures-storage arbitrage. Also, unless you regard the short-run supply curve (defined in terms of your observed empirical measure of inventories, different from the broader concept alluded to above) is perfectly inelastic, the non-speculation view has an equivalent challenge in terms of explaining why we don’t see changes in quantities.

  20. Movie Guy

    So where are all of these large inventory buildups that Jeffrey Frankel is implying are in existence? By nation state?
    Where is that supporting evidence?

  21. mike

    Anarchus:
    Long ago, before 1990, US agricultural subsidies played a big role. Demand growth wasnt keeping up with yield growth, and prices were falling, so the government stepped in with subsidies and set asides. Ag programs have changed over the years, starting particularly in 1990. While subsidies remain high, it is hard to see how they could be hugely distorting production today.
    There is still a lot of land in the US Conservation Reserve Program, over 30 million acres. That is mostly low quality wheat land. It would hardly put a dent in the current price situation.
    The amount of cropland used for crops over the last 80 years or so has been relatively constant, varying around your 300-330 million acres, with nearly all fluctuations coming from set asides, land retirement, or other government programs.
    Today, demand growth is amazing. Yeah, some of it is crazy domestic ethanol subsidies and import tariffs. But I imagine a lot of the ethanol would have happened anyway with the phase out of MTBE. It does make some sense as an additive, up to 10% of the fuel mix, and thats a heck of a lot of corn.
    What is surreal to me is demand growth in China. There is massive expansion of land in Argentina and especially Brazil to fill that demand (mostly with soybeans). Prices indicate it isnt coming close to equaling that demand growth.
    JDH:
    Regarding the concurrence of price rises across all commodities: at least for the key agricultural commodities, there is a lot of substitution in both production and consumption across the key staplescorn, soybeans, wheat, and to lesser extent rice. So these prices have always moved together. With ethanol there is now a much stronger link between agricultural commodities and oil. Also, a big fundamental factor, demand growth in China, affects all commodities. So I think a fundamental story might also explain why all commodities seem to be moving in the same direction.
    All that said, I’m ready to be convinced it’s the Fed’s fault.
    But I wonder sometimes how much of what we call inflation is actually something real, like yesterday’s oil embargoes or today’s demand growth, rather than a monetary phenomenon “first and foremost,” as Friedman would have said.
    -mike

  22. don

    I think growth in Asia is fundamentally linked to U.S. monetary policy. As long as our response to a slow-down in demand is geared to short-run policies to keep up U.S. borrowing, rather than constraints on Asian countries that syphon off much of that demand, prospects for global commodities prices appear rosy. It might be otherwise if U.S. policy took a longer-run view and recognized that a permanent state of excess domestic demand cannot be sustained forever.

  23. Josh Stern

    Numerous market commentators in recent years, and especially in recent months, have voiced support for the thesis that commodity prices are strongly influenced by investors/speculators. I believe this is part of the story. To analyze the effects of “fast money” on prices, analysts need to somehow try to model which asset classes are deemed to have the most positive price momentum and fundamental momentum at any given time. So I view Frankel’s analysis as incomplete because it isn’t looking at price momentum and fundamental momentum in various commodities as an explanatory variable.

  24. Anarchus

    JS: The accepted standard calculation for evaluating the influence of price-momentum crazies is to look at the open interest of the speculative holders. Commodity exchanges require buyers/sellers of their contracts to classify themselves as hedgers (businesses and people hedging cash positions with futures) and speculators (betting on up/down price movements).
    Though “hedgers” are not required to be pure hedgers and may even be “Texas hedging”, and not all (and maybe not even most) of those classified by the commodity exchanges as “speculators” are investing based on price momentum, there is a clear correlation over time between the open interest of speculative positions and upwards price movements in various commodities. I’d also note that this complex linked process has been complicated in the last couple of years by the rapid growth in ETFs specializing in physical commodities, with Gold being the poster child for the phenomenon.
    Maybe in part in anticipation of political criticism of the “speculative” run-up in food and other commodity prices, the exchanges have been raising margin requirements – though I like a good conspiracy theory as much as anybody, given the wild volatility and limit-price moves of the past few months, I personally think that the margin increases were mainly in response to the volatility of the markets, but that’s just my uninformed opinion.
    Last, one odd element of commodity futures markets that we’re doing more work on where I hang out professionally is the careful evaluation of open interest in key futures contracts versus the annual production and inventory stocks of the deliverable commodity. Because while futures contracts are tethered to the underlying physical by the delivery process at expiration, there is no governing mechanism that controls the amount of futures contracts bought and sold versus the amount of physical commodity outstanding — as the Hunt Brothers showed everybody back in 1979, it’s theoretically and practically possible to try to take futures delivery of more of something than may physically be accessible in the real world. Gotta hop.

  25. Josh Stern

    “The accepted standard calculation for evaluating the influence of price-momentum crazies is to look at the open interest of the speculative holders.”

    I don’t see how one would get from this level of interest to a calculation of the effect on the price. Why would the relationship be a simple one.

    What I was trying to get at above is the idea that there is always a large quantity of speculative capital looking for home it believes will give the best short term return – commodities, treasuries, govt. bonds denominated in non dollar currencies, corporate bonds, MBS/ABS, U.S. stocks, Euro Stocks, emerging markets, etc. I think it makes more sense to model a competition between as many classes as possible rather than just a competition between two (U.S. treasury vs. X).

  26. Jungle

    JDH, I think you’re overlooking the technicals, namely inflows into commodities from retail and institutional. These have arguably caused a disconnect between fundamentals (supply/demand) and price, and also increased the codependence between commodities.

  27. mike

    Interesting article on agricultural commodity prices:
    http://www.nytimes.com/2008/03/28/business/28commodities.html
    I haven’t read the research article referenced in this NYTimes article, but I do know other work by the authors and think they are unusually good in the field of ag. economics.
    Given so much talk about ‘momentum’ by some of the apparent traders that commented earlier, it seems plausible that the craziness really could be speculation unhinged to fundamentals.
    If it’s happening in ag., it’s may be happening for other commodities too.
    Can we blame the Fed for this? I’m not sure. It just looks like foolish traders chasing yesterday’s returns.

  28. Josh Stern

    I was also going to mention the same NYT article Jungle notes above. It seems that more participants in commodity futures increases demand for commodity storage, the costs of which must decrease at the margin. I wonder whether diverging prices may sometimes reflect fluctuations in the contribution of storage costs to delivered product.

  29. Anarchus

    Barron’s has an interesting article today blaming “the commodity bubble” on index fund buying:
    “To get a further idea of the impact of these speculative bets, Barron’s asked Briese [the analyst whose research is cited] to measure them against production in the underlying markets. He calculates that in soybeans, the index funds have effectively bought 36.6% of the domestic 2007 crop, and that if you add the commodity pools, the figure climbs to 59.1%. In wheat, the figures are even higher — 62.3% for the index funds alone, and the figure jumps to a whopping 83.6% if you add the pools. Betting against them as never before are the commercials, who deal in the physical commodity.”
    The article claims (probably accurately, I haven’t had a chance to check yet) that commodity index funds can end run the position limits in certain commodities by using swaps brokers . . . . . . more later.

  30. Josh Stern

    The Barron’s article is interesting. There is also a report on Bloomberg that Paulson is planning to propose a merger of the SEC and Commodities Futures Trading Commission.

  31. Anarchus

    I doubt there’s a link between the commodities boom and the Paulson proposal — the Bloomberg report refers to the major announcement coming up Monday that proposes sweeping reforms of the financial regulatory system – which between the Fed, the Treasury, the Office of the Comptroller of the Currency, the SEC, the CFTC and a myriad of other agencies and sub-agencies has been a complex mess for decades.
    Maybe this reform proposal will go through and the SEC and CFTC will merge, and maybe it won’t — but the timing is much more related to the housing collapse and the Fed’s bailout of Bear Stearns than anything else.

  32. Josh Stern

    I wouldn’t pretend to know Paulson’s thinking, but there are several other connections between the CFTC and current economic events of interest other than govt. reform. These include
    1) concern about commodity driven inflation;
    2) concern about relationships between highly leveraged positions and chain reactions in counterparty risk;
    3) increasing role of ETFs and mutual funds favored by retail investors in commodities speculation; and
    4) increased interest in trying to use market prices for various assets as leading indicators of economic fundamentals.

    The Barron’s article paints a picture of CFTC regs as being not very comprehensive and pre-dating these events. So while attributing any sort of current, much less forward thinking to Paulson might signal one’s naivete, it’s certainly possible that some of those factors play into his thinking.

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