Commodities Are an Excellent Predictor of Future Inflation

Commodity prices swing for many different reasons. From 2006 until 2008, rallies were based on the desire of investors to gain exposure to assets that were uncorrelated to stocks and bonds. The subsequent collapse was triggered by the need to exit risky positions and remain liquid. Examining daily swings, we can see factors as diverse as the strength of the U.S. dollar to weather patterns moving markets. With so many different levers, it can be difficult to gauge why prices are moving.

Despite this difficulty, one general rule still applies. Commodities are an excellent predictor of future inflation. When producers believe input prices will rise in the future, they drive commodities higher. When deflation is expected, prices will drop.

Since the Federal Reserve (Fed) has adopted a mission of creating inflation, we can look to commodity markets for an indication of their success. For a broad measure of commodities, I rely upon the Powershares DB Commodity Index Tracking Fund (DBC). DBC is broadly diversified across energy, metals, and grains; thus preventing one segment of the market from dominating prices.

Examining the chart, we see the large rise (blue line) and subsequent collapse (red line) that characterizes the volatility investors face. From there, an interesting pattern emerges. The three green lines have carved a saucer pattern. Since this is a weekly chart, the base building process has taken nearly nine months to complete. Given such a long duration, we should expect this base to be solid and eventually lead to higher prices.

Higher commodity prices would indicate the Fed is winning the battle with inflation. From the March low, the pattern was evident and appeared to be holding. Now it is under attack. As commodities fall, we see that the right side of the saucer under attack. If that price level does not stop the decline, we should expect DBC to retest $19. Knowing the threat of deflation nearly unhinged markets in early March, this is not a prospect I relish. DBC's base must hold or danger lies ahead.

Comments

[MarvinMBA:]

Judging from grocery prices, I would say there is a future in DBC. It could be the right time to buy but if it takes another dip just add to your position....Land, Labor, Energy are not cheap anymore and probably going higher with global warming good land for crops could be hard to come by...MarvinMBA

Jul 01 12:25 AM