Monday, October 20, 2008

Commodity bubble pops

The second chart shows the very strong correlation between the Canadian dollar and commodity prices. The first chart shows the value of the Canadian dollar in US dollars, relative to my estimate of what the purchasing power parity (green line) of the loonie is. Think of the green line as the "normal" rate of exchange, one that would put most US prices on a par with most Canadian prices.

Back in 2002-2003 the Canadian loonie was quite undervalued, and so were commodities. That was the tail end of the big deflationary squeeze the Fed put us through with its very tight monetary policy stance from 1995 through 2000. With dollars in short supply, the value of the dollar rose and commodity prices fell. US inflation also reached a significant low around that time.

Then came the Fed's easy money period, and that saw the dollar collapse and commodity prices soar. By March of this year the dollar had fallen to extraordinary levels, and commodities had reached stratospheric levels. Like the housing bubble, it couldn't last. Now we're seeing the frantic unwinding of commodity speculation and all the short dollar sales that made so much money for people in the past several years.

As the first chart suggests, the dollar is still weak (and the loonie is still strong relative to PPP), and by inference commodity prices are still strong, only much less so. We're rapidly approaching levels that are "normal" in an historic context. This has to be a very positive development. The collapse of commodity prices doesn't reflect a collapse of the global economy, but rather an unwinding of speculative excesses.

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