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Commentators claim that commodity prices have recently risen because of the expectation that the Fed seems about open the money taps much further. Until unemployment diminishes and credit supply recovers, the real economy will not be able to absorb a lot of additionally created liquidity. Therefore, this extra money will largely flow to the financial markets.

In the past years, investors have increasingly regarded commodities as a normal part of a properly diversified portfolio. So if more money becomes available to the financial markets this will not just put upward pressure on stocks but also on commodity prices. The RJ/CRB index breaching resistance at 284 confirms this. Many analysts anticipate an additional upswing. They base this on a looser monetary policy by the worlds’ biggest central banks (with the ECB the notably exeption) and consistently high economic growth on the emerging markets in Asia and South America.

However, from a non-USD investor perspective I could equally explain the rise since June in the RJ/CRB index based on dollar weakness (see also the chart). One could argue that the expectation of further quantitative easing by the Fed has depressed the dollar, which “automatically” drives up commodity prices (always quoted in USD).

This difference may appear subtle, but in the future it could be very relevant. I believe that the Fed will implement additional quantitative easing but only after economic prospects have deteriorated further. On top of this, the central bank may well start from a lower sum than the $1,000bn the market is presently hoping for. Not least because the Fed itself is increasingly vocal about the likelihood that the short-term advantages of large-scale quantitative easing do not compensate for the drawbacks in the more distant future. The Fed believes that the short-term positive effects on growth will be minimal. For example, a frequently used economic model shows that an additional stimulus worth $2,000bn will merely generate 0.35% higher growth in 2011 and 2012.

As soon as it becomes clear that the Fed is not going to open the money taps as widely as investors currently expect, asset prices will likely come under downward pressure. Growth expectations will also be toned down. In theory, this does not need to impact negatively on commodity prices.

Most economists expect growth in Asia to stay elevated, while on balance the monetary policy will remain very expansionary. Yet this outlook will change once falling asset prices and lower growth expectations cause investors to flee to safe havens. The most important safe haven is the US. This strengthens the dollar. Just like dollar weakness has a positive effect on commodity prices, a stronger dollar is bad news for commodity prices.

In the coming quarters I expect, on balance, the RJ/CRB index to drop towards 230. Moreover, the emerging industrial countries, where growth has so far been rapid, will from now on likely also be affected by lower economic growth in the US and Europe (their most important markets). This too, will have an adverse effect on commodity prices.

However, should the Fed immediately decide to flood the system with liquidity, there is not much left to prevent the dollar to drop further, while pushing up commodity prices to new bull markets high. Commodity bulls; forget the supply-demand fundamentals, but watch the Fed and the USD.

Disclosure: No positions

Source: Commodity Bulls Should Be Grateful to the Fed