Friday, March 21, 2008

Commodity Price Rally Not In Danger

I've been right about almost everything in terms of both macroeconomic trends and market movements, with my bearish stance on the U.S. economy, the U.S. dollar, the Canadian dollar and the U.K. pound and my bullish stance on China's economy, commodities, the yuan, the euro, the yen and the Swiss franc. The only area where I've been frequently wrong is in predicting the exact size of central bank movements. I didn't expect the Fed to cut on January 22, just 8 days before a regular meeting, I didn't think the Swedish Riksbank would raise interest rates earlier in the year and I thought the Fed would go for a 100 basis point cut earlier in the week. On the other hand, almost all other analysts made the same mistakes on these occasions. Central bank behavior is particularly hard to predict as they depend on the whims and psychology of central bank board members. While macroeconomic movements and market movements are also related to psychological factors of the general public and market participants, this is mostly relevant in the short term. Medium- to long term trends can be identified by focusing on the relevant data and using correct economic theories to analyze this data.

Returning to the Fed's smaller than expected cut of just 75 rather than 100 basis points, this was taken as an excuse by many traders to sell of gold, oil and other commodities and to a lesser extent also trade up the U.S. dollar against most currencies. This will inevitably cause some to fear or hope (depending on their current position) that this will mark the end of the commodity bull market and the dollar bear market. However, I have no doubt that this is simply a normal correction. There are always temporary rallies during bear markets, as well as temporary sell-offs during bull markets. For example, while oil has risen from $10 per barrel in 1999 to over $100 per barrel now, this rise hasn't come in the form of a straight line. There have been many temporary declines, with some lasting for several months. For example, after peaking at $78 per barrel in August 2006, oil plummeted to as low as $50 per barrel in January 2007. And more recently, after peaking at more than $100 per barrel in early January this year, oil fell to less than $90 in early February. Yet these temporary declines have always been reversed and new all-time highs have been set after that.

The reason why there are always temporary deviations from the trend is that while markets in the medium to long term is driven primarily or almost entirely by fundamentals, it is driven primarily by sentiment in the short term. And sentiment can and do go in either way, sometimes contradicting and sometimes reinforcing the longer term trend.

But few, if any, trends last forever, so how do one determine whether deviations from the previous trend is the end of the trend or simply a temporary deviation? Well, the way to determine that is to check if the fundamental factors driving the trend are still present or whether they have been swept away.

As I argued in my review of Jim Rogers book Hot Commodities, the commodity price rally has been driven by two factors: the nonmonetary structural factors discussed by Rogers in the book, and the inflationary monetary policies by central banks in general and the Federal Reserve in particular. Have any of these two factors been swept away? In short: no.

There have been no signs of a general increase in supply capacity in the recent week or recent months, for that matter. Meanwhile, the structural demand increase from the rise of particularly China is still in place. While I expect China's GDP growth to fall during the first quarter of 2008, this is only a temporary factor related to large supply disruptions caused by the unusually cold and snowy winter (so much for "global warming"). Growth seems likely to pick up again during the second quarter as these supply disruptions will by then be over and as increasing domestic demand will compensate for slower growth in export demand.

And that 75 basis point cut from the Fed certainly didn't represent a shift to anything remotely similar to tight monetary policy. Cutting interest rates by 75 basis points still represent a dramatic easing of monetary policy, at a time when it was already highly inflationary with real interest rates well below zero. Money supply growth remains high and will likely get another shot in the arm after this cut. And as the recession continues and gets deeper, the Fed will nevertheless feel compelled to continue with their interest rate cuts. The exact pace of these cuts is unclear as this again depends on the unpredictable whims of the FOMC members, but there can be little doubt about the direction of interest rates.

In other words, the fundamental factors driving the boom are still in place. And that means that although it is possible that prices can decline a bit more in the short term, prices will soon rise again and hit new all time highs.


Anonymous newson said...

interestingly, the eem chart (log scale) of the emerging markets eft looks to have decisively broken a 5 year uptrend. the increasing volume on downtrades would suggest november was a top.
i agree with your bullish long-term view on commodities, but think there could be some very nasty downward moves in the short/medium term, as the yen-carry-traders de-leverage.

5:26 AM  

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