Commodities Conundrum

The commodity prices are down sharply and there are talks of the famous commodity super cycle going bust as the US dollar reverses course, bringing an end to the wild rise in all dollar denominated assets, particularly Commodities, which were a big hit in last six and half years. Oil and Gold prices are off about 30% from their all time peaks earlier this year and a near term recovery looks unsustainable.

However, it might not be game over for commodities and we may well be in a corrective phase of a long term bull run for natural resources as a full-fledged slowdown in the global economy would only be followed by a cyclical upturn in years to come. It is needless to say that economic boom means demand for assets of all kind and in this particular case – from all over the world.

Current Downturn Is No End 2006

The recovery in the global equity markets after the US credit filled boom ended in 2001 witnessed a tremendous appetite for commodities like industrial metals, grains, soft, bullion and energies alongside it as the burgeoning demand from emerging economies, particularly China and India made up for a strong story on demand front. However, enter 2008 and after an initial period of unprecedented and unforeseen euphoria, commodities are in a swoon. This is not end 2006 when the rising global interest rates had taken a toll on major commodities. The price action in the commodities spectrum in last couple of years is an apt example of how the traditional commodity pricing theories have been put to a scrupulous test with prices for all assets rising in unified fashion even as the global economic outlook was turning from grim to gloomy. How to explain commodity prices go up while the economy turns down? If strong economic growth was not the explanation for the large increases in virtually all commodities, then what was?

World Headed For A Synchronized Slowdown

Since the US housing market took a transatlantic flight in August last year and the world looked headed for a significant, synchronized slowdown, the first in seven years, no factors were at play to provide a support to global commodities on a fundamental front. It was the weakness in US dollar calling the shots instead. The idea that commodities offer great hedge in times on economic uncertainty was also at the helm with falling equities making investors flock to hard and soft assets alike. Indeed, the near vertical rise in the prices of virtually all the commodities in last one year, particularly crude oil and base metals defied the basic economic principles of demand and supply.

Breaking Up Commodity Price Cycle

Before we analyze the commodity price trends in the last one-year of turmoil, it is important to do some historical hauling on the subject. The gigantic commodity price cycle could be phased out in three stages. The initial stage, where the argument was strong growth in developed as well as developing economies, followed soon after the recovery in the global markets started in 2002 and set the ball rolling for a boom that seemed built to last. The middle stage, which could be argued to have started somewhere in 2004-2005, was based on an embedded growth perspective, an idea which fostered on premise that global growth would continue uninterrupted for years.

The third and the most critical stage of the boom arrived last year and defied the primordial economic fundamentals to make the world believe that we are entering into a perennially high commodity price regime, insulated even in troubled economic times. This was further spurred by the monetary charade by the US Fed, which cut the interest rates too much and too fast, toppling the US dollar to all time lows and pushing up the dollar denominated assets in turn.

At this time, it dawned upon most of us that the last leg of the commodity super cycle was fueled to a large extent by butterfly effect that linked burst of massive credit bubbles in US to commodity prices. The last leg of the rally was an implication of the punishing downside of the global financial market integration, a downside that the world has witnessed on numerous occasions in the past, namely the Asian financial crisis, the LTCM episode or the currency crisis in South America.

Historically, Commodities Edge Out Other Asset Classes

However, it is hard to believe that the world could get a reprieve from the commodity price inflation in years to come and the era of global disinflation might be hard to experience as a response to good old supply-demand fundamentals. The empirical evidence is very much on side of commodities when it comes down to fighting recession as revealed in a groundbreaking study from the Yale School of Management’s Center for International Finance entitled Facts and Fantasies About Commodity Futures in 2005.

Leave The Markets On Their Own

Markets work best when they are left on their own. However, the Fed does not seem to believe in it. As soon as the Fed started its rate cutting campaign, the interconnectedness between currency and commodity markets. The Fed, characteristically, erred on caution in cutting rates too far and too much, in turn sending financial contagion around the globe. Only if the Fed had not cut the rates so drastically, it would have helped the global asset markets to sort out the things on their own. The slide in equities, which Fed managed to extend by a few months, would have been much quicker. However, the most important impact would have been on commodities, which experienced an upshot of gigantic proportions, pulling the multi-decade secular price trends into bubble territory. Bubbles, as we all know are called bubbles because they cant last forever.

Give It Some Time!

To sum it up, the softness in commodity prices might stay around for some time, though it might not be the end of the world for commodities. The severity of the current downturn is just a counter action to the superfluous enthusiasm witnessed by commodities in the last leg of its price cycle. Dollar’s radical upturn may soon fade away, as the worse still awaits on the US financials front, with the Lehman disaster being just the tip of iceberg. The overwhelming debts in the United States, coupled with the strong probability the U.S. dollar will continue to fall, is one major reason natural resource prices might still be favorites. Futures market are not really leveraged casinos, as put forward by critics who blamed the unusual rise in the commodities over the first half of 2008, but they act upon laws of demand and supply only. That they act a little too fast and a little too drastically is only a part of the game called financial markets.