Tuesday, February 2, 2016

Are commodities bottoming out?

The world is still obsessed with the prospect of Chinese weakness, Fed tightening, collapsing commodity prices and super-low oil prices, all of which might—or so the thinking goes—tip us into a deflationary downward spiral. When a narrative such as this becomes so widespread, it's easy to miss important clues to the contrary. I note here a few contra-indicators which bear watching:

The first chart above shows a short-term view of the CRB Raw Industrials commodity index, while the second gives you the long-term view of the same index. This index is composed of some pretty mundane commodities (hides, tallow, copper scrap, lead scrap, steel scrap, since, tin, burlap, cotton, print cloth, wool tops, rosin, rubbers), most of which do not have associated futures contracts and are therefore relatively immune to speculative forces and thus more likely to reflect the changing balance between supply and demand. Since late November, the index is up more than 5%—after tumbling more than one-third from its early-2011 high. As the second chart shows, the plunge in recent years is similar—if not greater—in magnitude to other plunges, all of which were followed by reversals to the upside. Maybe the Great Commodity Price Collapse has come to an end?

As the chart above suggests. Commodities have a strong tendency to move inversely to the dollar's value vis a vis other currencies (note that the y-axis for the dollar is inverted). It might be the case that the dollar is topping out here, just as commodity prices bottom out. [Update: the original chart was mislabeled, now corrected with data as of Feb 3]

This index (see chart above) of the dollar's value against a small basket of major currencies shows that the dollar has been flat for almost a year, another indication the dollar is topping out.

What could be the impetus for the dollar to stop rising? Simple: the perception that the U.S. economy is weak and that therefore the Fed is unlikely to raise rates aggressively. Indeed, I think that process is already underway. Since June of last year, March '18 Eurodollar futures (tied to 3-mo. Libor) have fallen from 2.4% to 1.2%. The market was expecting at least four tightenings by the Fed and now it is only expecting two more over the next two years. With the greatly-reduced prospect of higher short-term rates (and less-than-previously-expected Fed tightening), the dollar is losing some of its appeal.

So, whatever it is that is slowing down the U.S. economy is also reducing the appeal of the dollar, and that in turn is helping to put a floor under commodity prices. And the end of declining commodity prices—particularly if this includes oil—should help alleviate fears of a deflationary death spiral. Markets have a way of resolving things if left to their own devices.

This is not a call for shorting the dollar or going long commodities. It should be taken more as a note of caution that the prevailing wisdom may be getting long in the tooth, and changes may be waiting in the wings.

UPDATE (Feb 3): Well, this change seems to be unfolding all of a sudden. The market senses that the economy is weak, and that therefore the Fed is unlikely to raise rates aggressively. That directly undermines the value of the dollar, which had been boosted by the perception that the US economy was doing much better than others, and that the Fed would be boosting rates. A weaker dollar (which  today is on track for its biggest drop in seven years) provides support to commodity prices, and that is showing up in a huge increase (7-8%) in oil prices today. The stock market is breathing a sigh of relief, as the threat of tight money recedes and higher oil prices reduce the risks of widespread bankruptcies in  the oil patch.


William said...

RE Fed: Fed's Esther George - Damn the Torpedoes; Full Steam Ahead

Federal Reserve Bank of Kansas City President Esther George said recent financial turmoil was anticipated and is no reason to delay further interest-rate increases.

“While taking a signal from such volatility is warranted, monetary policy cannot respond to every blip in financial markets,” said George. “The recent bout of volatility is not all that unexpected, nor necessarily worrisome, given that the Fed’s low interest rate and bond-buying policies focused on boosting asset prices as a means of stimulating the real economy.”

George said the recent decline in oil prices and strengthening of the dollar could slow U.S. growth but they don’t change the overall forecast for continuing expansion. “Despite these headwinds, the U.S. economy has proven itself to be resilient to a wide range of shocks in recent years, including sluggish growth abroad,” she said.


So what if this is the Yellen's "Volcker Moment"? I'm certain that they realize that many investors count on the "Fed Put" and for the Fed NOT to go ahead with 4 interest rate hikes of 1/4% in 2016. Perhaps the FOMC will do what is necessary and right for the long term health of the US economy knowing full well that the economy will suffer to some extent and that some bubbles will burst - like Volcker knew.

Perhaps they realize that they better do it now before Trump or Cruz are elected and Republicans clamp down of the Fed's flexibility.

Benjamin Cole said...

Great post.

I like POT (Potash) here...also Hong Kong hotel stock Regal...the HK exchange is trading at 7 times earnibgs btw.
You can collect 9% dividends and wait out the cycle....
Esther George is a lightweight Fed martinet, never ran a business in her life...what if the FOMC had seats for manufacturing, real estate, tourism and yes, even labor?

Is an FOMC composed entirely of academic ninnies and little tight-money boys in short pants a good idea?

William said...

This is the third time that Central Banks have re-inflated the world economy since the 35% crash in the Dow Jones average in late 1987 (after the DJ had risen 30% in earlier 1987). The Federal Reserve's reaction became known as the "Greenspan Put".

William White whom I quoted after Scott's last post explained the problem that has occurred when Central Banks attempt to prevent the economy's normal and necessary reaction to excess speculation and a huge build-up debt. The Depression era economist Fisher's research referred to it as the "debt / deflation" cycle. I highly recommend that everyone read William White's current thoughts at the link below. He explains himself much better than I can.


Benjamin Cole said...

William White is a another little boy in short pants, pompously pettifogging about inflation and other bogeyman. Never ran a business in his life.

Gadzooks, the 10-year Treasuries are at 1.87% today. Yeah, institutional investors are betting on inflation.

White talks about excessive central bank stimulus. Yes, the central banks have been so easy that we see deflation in commodities, flat prices in manufactured goods, and dead wages in the USA. In fact, auto prices in the US have not increased in 20 years. That is the runaway inflation so often promised. (Due to property zoning, we do see price hikes in housing. Not a PC topic. You mean "better neighborhoods" have zoned out condo towers? Let's not talk about that! Free markets and highest and best use of property be damned to hell.)

The US just reported deflation on the PCE for December, despite our housing markets.

The screaming ninnies at central bank staffs are hysterically squeamish about inflation, and have been having heebie-jeebie fits since 2008. But in the real world? Inflation is dead in the water, and economies are suffocating.

Global borrowing is up, as governments try to prevent depressions and revolts.

Sheesh, I hope the Fed pays off a few trillion dollars more of US Treasuries soon.

Right now, the Fed can raise rates the way a kangaroo can fly. It ain't happening, jack.

One thing White said is true: If the central banks asphyxiate the global economy (and the Fed seems to be trying), then yes a lot of debts won't get paid off.

On the other hand, if we have robust growth and moderate inflation, debt service becomes easy.

Oh, why would we choose prosperity?

Matthew Grech said...

Excellent comments, Benjamin.

For another take on how the Fed's move in December wasn't the mistake itself; rather, it was the culmination of almost a year a mistake-mongering, read this:


Yes, it would be best if fiscal policy started really pushing pro-growth initiatives. In the absence of those, however, monetary policy takes on even greater import. The potential good news is that this latest chapter is easily correctable. In fact, the FF futures market now sees no rate hikes in 2016. Will the Fed listen to the markets or will it listen to educated know-nothings like Ms. George?

Frozen in the North said...

Well the Baltic Dry Index seems to say otherwise. Granted its not perfect -- for many reasons, it remains that as an indicator of shipment of bulk good (aka commodities) it does a decent job. it is still showing a serious down trend. of course the BDI could be a lagging indicator, and your measurement seem to show that things are looking "maybe not up, but stabilizing"

Just saying

marcusbalbus said...

i love the way you put a peg in the ground to come back to later if right, but won't put any dough behind your "calls". man up and take some positions w $$ risk.

William said...

Bill Gross to Central Banks: "How's it workin' for Ya?"


William McKibbin said...

We live in a bizarre economy -- the possibility of negative interest rates -- stocks rising in an environment of declining earnings -- stocks positively correlated with oil prices -- all way too scary for me -- investors have every right to be terrified -- in the newest twist, I suspect that oil prices will soon correlate negatively with other commodities -- in other words, oil prices will rise along with stocks, while gold, copper, and corn collapse to new lows -- the only winners in this economy will be the beneficiaries of world-war, including the military-industrial complex, the medical establishment, Wall Street, and unionized government workers -- I am completely terrorized by military-industrial Republicans and big government Democrats who are both likely to get their way -- I urge non-accredited investors to take cover and keep a sharp lookout for the four horsemen of the apocalypse.

PS: Consider this recent report on weak earnings -- yet the stock market climbed on the day of its release -- terrifying...

William McKibbin said...


Benjamin Cole said...

Dudley's commentary was well-received.

Still, with inflation well below target, and the global economy faltering, in the US economy slowing, why is the Fed talking about tightening?

Should not the Fed be talking about QE and cutting interest on excess reserves?

William McKibbin said...

I suspect the Fed will move toward negative interest rates instead of raising rates -- just more twisting if you ask me -- I'll be watching for Scott's take on negative interest rates now that the ECB and BoJ have gone negative...

William McKibbin said...

PS, I am deeply troubled by earnings...

Scott Grannis said...

I don't think the Fed has to resort to negative IOER. At this point, the market simply needs reassurance that the Fed will not raise rates aggressively. That's what the market is pricing in now, and that's what Dudley was hinting at recently.

William McKibbin said...

I agree with Scott regarding negative interest rates -- negative interest rates twist reality in my mind...

Benjamin Cole said...

Scott and William: if a central bank gets to the point that negative interest rates are a proper policy, then it has become so far behind the curve as to be in the failure zone already.

Egads---negative interest rates! Soon to be followed by perennially weak equity and property markets, ala Japan.

Cut taxes, print money, unzone property. Imagine the investment and building boom we would see on the Pacific Coast if property zoning was banned, and free markets and highest and best use prevailed.

Scott Grannis said...

I agree in part with Benjamin: instead of having the central bank adopt negative interest rates to spur an economy (a doubtful proposition to say the least), it would be far better for legislators to adopt genuine supply-side stimulus policies like lower marginal tax rates.

William said...

Thanks for the invite, Benjamin. First of all, I am no where close to being in a league with Dr Scott Grannis. But I read fairly broadly and I have noticed one thing: experience investors of billions of dollars and hedge fun guys seem to ascribe to the theories of Irving Fisher (Debt / Deflation) and Hyman Minsky (Stability lead to Instability). They believe that the 35% build up of private-public debt since 2008 - in only 8 years - is the result of central banks near zero interests rates. They are also extremely concerned about China's banking system which has ballooned from $3 to $34.5 trillion between 2005 to 2015.

Fisher's debt / deflation theory frowns upon such huge increases and Minsky believes that the central banks with their ZIRP and QE have bought stability which in the end will lead to instability. I posted links to various investment professionals who have voiced these concerns. Most of the folks I read believe that the US fiscal side MUST get its act together. But they believe that would include an overhaul of the tax code,a restructuring of Social Security and Medicare and intelligent infrastructure programs because of the incredibly low long term interest rates.

William White said: "“It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit.”

Benjamin Cole said...

Well, everyone seems to have their favorite economic cure-alls. Mine are FICA tax cuts, unzone property, and QE hard and heavy. When there are "labor shortages" in America, sing Hallelulah and kill off the food stamp program. And the F-35 boondoggle-arama.
That's my story and I'm sticking to it.

Benjamin Cole said...

151k new jobs in US in Jan. Wages up 2.5% YoY. The market says that gives the Fed ammo to tighten the money supply. Egads.

Presently, the Fed appears to be keeping short-term rates artificially high. Other central banks, such as those of Switzerland and Japan, have actually gone to negative interest rates, and still they end up with too much capital being undeployed and piling up in banks. There are global capital gluts.

It doesn't appear that cutting taxes on those who have capital to invest is the right course presently.

Deep tax cuts on people who will spend the extra cash is probably the way to go.

And shrink government and undo property zoning.