Wednesday, January 21, 2009

Commodities are bouncing (2)

I first noted this in early January, and it's still the case: commodity prices in general appear to have bounced in the past few months. The big selloff in commodities happened over the course of the fourth quarter, and it certainly looks like this had a lot to do with the unwinding of carry trades, the unwinding of speculative commodity positions, and the deleveraging and drawdowns of hedge funds.

Interestingly, though, the pattern applies even to commodities that are not traded on futures exchanges. That tells me that two things were going on in the fourth quarter: 1) liquidation of speculative long positions, and 2) a major slowdown in global demand for commodities. Now we're on the other side of that trade. Leverage is starting to look much more attractive on the margin, now that large institutions can borrow at 1% or less, thanks to easy money from the Fed. Plus, commodity prices are down hugely from earlier highs. But perhaps most importantly, higher prices for raw industrial prices suggest that global demand is once again picking up.

I note also that a large number of commodities, including the energy complex, appear to have hit bottom at levels that were last seen in 2004. That was the year when the global economy started roaring ahead. U.S. exports surged 13% that year, thanks to strong global demand. Commodity prices rallied strongly in late 2003 and 2004 as demand for just about everything picked up. That prices have only fallen back to levels last seen when the global economy was robust is another indicator that fears of deflation are overblown, and it also suggests that we have seen the worst of the economic news.


Unknown said...

Scott, how much of the recent move in commodities prices do you attribute to fluctuations in the dollar versus actual increases in demand. The dollar gave back some of its recent strength in December and commodity prices in general seemed to benefit. In recent weeks the dollar is strengthening again and it appears that commodities are on the short side of this transaction.


Scott Grannis said...

For most of the past year there has been a pretty strong correlation between the dollar and commodities: a stronger dollar was accompanied by a decline in commodity prices. That relationship seems to have weakend in the past month or so. The dollar hit an air pocket in December, only to bounce back in January; commodity prices bottomed in December and have since strengthened despite a stronger dollar.

When commodities trade in inverse relationship to the strength of the dollar I would take that as a sign that monetary policy is the fundamental driver (e.g., too much money weakens the dollar and increases the demand for commodities). But with the dollar now rising alongside higher commodity prices I'm tempted to think that this is a sign of a return to healthier economic conditions. But it's still early to make a definitive call.

jj said...

Scott, recently saw an article that said according to the "Taylor Rule" fed funds should be at a negative 6%, hence the need for quantitative easing. If possible could you fill me in on the "Taylor Rule" and your thoughts on it. Thx.

Scott Grannis said...

The Taylor Rule has generally done a good job of indicating where the Fed should set the Federal Funds rate. I don't agree with the way it's formulated, however, since it draws from the lessons of the Phillips Curve. The Phillips Curve essentially says that inflation rises when an economy grows faster than its "potential", and inflation falls when the economy is growing slower than its potential.

So if the economy is, like now, actually shrinking, then the Taylor Rule recommends a huge reduction in the funds rate.

The Taylor Rule also calls for adjusting the funds rate based on whether inflation is above or below its "desired" rate, which most seem to think is around 2%.

So with inflation currently around zero, the rule would recommend a reduction in the funds rate.

Today's combination of zero inflation and a sharp recession would therefore call for a negative funds rate. For followers of the rule, this leaves the Fed with no alternative but to resort to quantitative easing.

Instead of using the Taylor Rule, I would prefer to have monetary policy be guided by a combination of market prices: e.g., the value of the dollar, the price of gold, commodity prices, real interest rates, credit spreads, and the shape of the yield curve. All of those give me clues about the state of the economy and the relative stance of monetary policy. As it happens, they would also recommend quantitative easing at this time.

Interestingly, if we were on a gold standard, the price of gold would be telling the Fed to tighten policy, thus raising interest rates. But then if we had been on a gold standard for the past 20 years, we might never have found ourselves in the situation we're in.

jj said...

Thank you for the explanation, clear, cogent, and concise as always.