Commodities spanked; USD strengthens; Deflation in core producer prices

Commodities taking a bath!

Things are starting to make a bit more sense again.  Last week I said the following:

I have repeatedly stated that the US will NOT be the first domino to fall.  It should be very clear to everyone that if any currency is doomed, it’s the Euro.  Though the USD will take a shellacking over the longer term, there will likely be a capital flight out of Europe and into the ‘safe haven’ currency of the USD.

If jitters persist in Euro-land, expect a strengthening greenback to take some substantial steam out of the rapidly rising commodity markets.”

Today we see that a coming eurozone crisis has in fact caused the continued flight into the USD as it is rising against the loonie, pound, euro, yen, and Aussie dollar. This coupled with increasing concerns about the level to which the People’s Bank of China will go to stem credit expansion has had a predictable effect on commodity prices, which are tanking as we speak.

At noon, gold has shed $35 an ounce and is now down almost $100 an ounce in the past few trading sessions.  Silver is also down, now closing in on a 15% decline in a few days.

This was predictable and will present a nice buying opportunity shortly.  You’ll know when this round of selling is coming to an end when the Committment of Traders reports show net spec long positions in commodities coming back in line.

Speculation, not inflation buoying markets

On Saturday I wrote that “CFTC committment of traders continues to show significant speculative long positions in a number of commodities.  As I’ve noted before, these large speculative positions offer interesting contrarian opportunities.”

David Rosenberg echoed these same feelings on Monday in his daily commentary, noting that near-record net spec long positions existed in oil, gold, copper and significant long positions in silver and the loonie and the euro.

As he noted, “it may pay for the time being to avoid the areas of the market where net
speculative long positions exist and is in the process of unwinding. Long covering is a critical source of selling pressure.”

Indeed.  I think the QE2 speculative buying in commodities is running its course.  As I have repeatedly said, speculation in commodity markets is NOT the same thing as inflation.

Long-term supply reductions and stable demand will cause long-term price appreciation.  I believe in peak oil and think it will ultimately drive oil prices higher in the long term, though the next few years are a coin toss.  But this is NOT inflation!


Understanding inflation

Let me illustrate the simple concept of inflation by contrasting three ways that a commodity can rise in value:

*Reader note:  I am fully aware of the traditional distinction between cost-push and demand-pull inflation.  For the sake of readability, I have chosen to explain them in simpler terms.  If you get demand-pull and cost-push inflation, this part of the post is not for you*

1)  Short-term speculation:  Money supply remains stable.  Commodity supply remains stable.  Demand remains stable.  But the perception of future inflationary pressures cause speculation in commodity markets, thus buoying prices over the short term.  I believe the recent parabolic move in some commodities were driven by this dynamic.  Watch for this in the CFTC COT reports.

2)  Supply restriction:  Money supply remains stable.  Commodity supply decreases (or remains stable) while demand remains stable (or increases).  If OPEC decided to stop exporting oil, the price of oil would shoot to the moon.  Similarly, a long-term reduction in production and/or increase in demand with stable production causes long-term increases in the value of the commodity.  While this resembles inflation, it is tied to supply and demand, not the money supply.

3)  True monetary inflation:  Monetary supply expands at a greater clip than population expansion, commodity supply, and consumer demand.  Consider a small island with 3 people on it.  The currency is seashells.  There are 9  seashells in total on the island divided evenly among the three inhabitants.  One inhabitant owns a coconut tree, the only source of food on the island.  The coconut tree grows two coconuts.  The owner eats one and sells the other.  The maximum price that one of the inhabitants can pay for a coconut is 3 seashells.  But suppose that a storm washes up 10 more seashells and each of the two hungry inhabitants finds 5 seashells each.  Now what do you think will happen to the price of the coconuts.  Obviously they will rise.

It’s a simple, silly example but analogous to how an increase in the money supply can cause inflation.

In the US, M3 money supply is still contracting.  In Canada, we have seen increases of late, but keep in mind that our credit bubble has not yet burst.  When the oft-discussed forces of debt deleveraging and increased savings rear their heads (both now a given), we will see our money supply contract too.

THIS is deflation and inflation in layman’s terms


Can you have commodity price inflation in a the midst of credit deflation?

Of course you can.  Just look at the price action of commodities over the past few weeks.  Now that’s just speculative buying lifting those prices, but you can have persistent price increases in some commodities even as the money supply shrinks.

If peak oil production is as close as it sounds, we absolutely will see the price of oil rising over time as supply constricts.  It’s a given that demand will constrict also as incomes fall during bouts of deflation, but the question is which will fall more on aggregate.  If demand falls at a greater pace, it will keep a lid on prices.  But there’s a limit to how much demand can be cut.  Also important to keep in mind is that commodity markets are global markets, meaning that demand doesn’t have to come domestically to cause a rise in prices.  If a nation depends on imported commodities, they are at the mercy of the global commodity markets.

Ultimately, sustained price increases in certain commodities during a time of deflation has a two-fold effect:

1)  It undermines profits from companies who find that they can’t pass the increased costs on to consumers without seeing significant drop in demand

2)  It lowers our standard of living as we can afford less and less of these commodities

Interestingly, we found out today that the producer price index in the US fell much more than expected in October:

U.S. producer prices drop most in four years

“U.S. core producer prices unexpectedly fell in October to post their largest decline in more than four years, according to a government report on Tuesday that underscored the Federal Reserve’s concerns about the low inflation environment.”

“It’s certainly undercutting all the arguments that inflation is ready to break out here.”

“Commodity prices have come up, but this data shows producers can’t pass it along.”

Interesting.  The future will be deflationary.  There is NO hope for a sustained increase in house prices as we’ve seen over the past 10 years.  Real estate relies on credit to keep the party going.  Therefore, as credit contracts, real estate gets crushed.

I believe many commodities will have more downside risks than upside over the next few years.  I think silver/gold will rise or at least maintain purchasing power as they will increasingly be viewed as a physical currency.  Physical currencies do well during bouts of deflation.  Deflationary forces cut into the tax base of a country, making its bond debt harder to repay.  This instability will be the driver of sustained demand for bullion.

I think oil and nat gas are going to move higher over time simply because of long-term supply constraints, though they may fall significantly over the short term.  If you haven’t educated yourself yet on the peak oil theory, you owe it to yourself to do so.

I also think grain prices have a stronger future, meaning I’m far more bullish on farm land that I am on residential real estate, though farmland too will see price compression as credit contracts.

At the end of the day, even the most ardent deflationists believes in inflation over the longer term.  We just disagree on the timing.  I hope that clears up some of this misunderstandings about inflation and deflation in the economy.


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4 Responses to Commodities spanked; USD strengthens; Deflation in core producer prices

  1. Vinny says:

    Thanks for the insights Ben!

    Quick one..How do we account for the oil price action from $140 to $ 30’s ? Surely demand did evaporate, but was the fall justified by demand itself. And OPEC actions were I believe consequence and not cause for the rebound that followed. Do you hold a view that speculative positions were the driving force behind that price action?

    I ask this as except for bullion/silver (monetary tangibility) , other non-rural commodities price action is really far-fetched with future demand expectations for the same.

    Any thoughts appreciated.

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