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Sam Sam the Bubble ManBen Ben the Bubble Man

Critics of Ben Bernanke’s Quantitative Easing 2 policy — purchasing $600 billion in Treasury securities — are in general agreement that the move is potentially inflationary. But there is little consensus yet on what form that inflation will take. Will it be a generalized increase in the Consumer Price Index? Will it morph into soaring commodities prices? Or will it take some form as yet unknown?

A new paper written by Ke Tang and Wei Xiong provides evidence in support of the view that QE2 could kick off a commodities bubble. Tang, an economist with the Renmin University in China, and Xiong, a professor at Princeton University, don’t leap to that conclusion. But they do illuminate a mechanism by which excess liquidity could be funneled into the commodities markets.

In “Index Investment and Financialization of Commodities,” published by the National Bureau of Economic Research, Tang and Xiong make the case that the prices of major commodity groups — petroleum, grains, livestock, metals and tropics — traditionally moved independently of one another, but since 2004 have begun to move in concert. The reason, they contend, is the “financialization” of commodity markets.

After the collapse of the equity market in 2000, investment banks began to promote commodity futures as a new asset class for prudent investors, arguing that returns on commodities and stocks were negatively correlated and that commodity futures could be used to offset portfolio risk.

As a result, various instruments based on commodity indices have attracted billions of dollars of investment from institutional investors and wealthy individuals. … As index investors typically focus on strategic portfolio allocation between the commodity class and other asset classes such as stocks and bonds, they tend to trade in and out of all commodities in a chosen index at the same time.

Since 2004, the two economists have found, the prices of different commodities have increasingly moved in concert as financial investors move in and out of the commodity asset class.

As a result of the financialization process, the price of an individual commodity is no longer simply determined by its supply and demand. Instead, commodity prices are also determined by a whole set of financial factors, such as the aggregate risk appetite for financial assets, and investment behavior of diversified commodity index investors. … Portfolio rebalancing can spill over price volatility from outside to commodities markets and also across different commodities.

This fundamental shift in commodity price dynamics, argue Tang and Xiong, has

profound implications for a wide range of issues from commodity pricers’ hedging strategies and speculators’ investment strategies to many countries’ energy and food policies.

Let me be clear: Tang and Xiong do not opine about QE2. But their insight into the changing nature of the commodities sector does suggest that a broad-based commodities bubble — as opposed to a mere inflation — is more likely to emerge than it was before 2004.

As I argued in “Boomergeddon” and updated in ”How QE2 Is Feeding a Commodities Bubble,” the fast-growing developing nations — China, India, Brazil, Turkey and all the rest — have emerged as the drivers of demand for commodities in the global economy. Their voracious requirements for energy, raw materials and food are growing faster than new supplies can be developed, setting the stage for a long-term, secular increase in commodity prices, only partially obscured by the cyclical ups and downs of the U.S., Europe, Japan and other developed economies.

If QE2 creates excess liquidity that cannot be usefully absorbed in the U.S. economy, and if investors fear U.S. inflation and devaluation of the dollar, much of that liquidity will flow into either the currencies of developing nations or into commodities, both of which will hold their value as the U.S. dollar is debased.

What Tang and Xiong have done is identified a little-appreciated mechanism by which that hot money can be channeled into commodities. Thanks to the proliferation of commodity indices such as the S&P Goldman Sachs Commodity Index, the Dow-Jones UBS Commodity Index, the Rogers International Commodity Index and the Deutsche Bank Liquid Commodity Index, investors can make a strategic allocation of capital to “commodities” far more easily than they could 10 years ago.

The growth of the commodity index is a global phenomenon, driven in part by the desire of investors to hedge against the dollar. Say Tang and Xiong:

A significant fraction of the investment flow comes from international investors who are exposed to shocks to the U.S. dollar exchange rate. When the U.S. dollar appreciates, the same commodity with prices in dollars becomes more expensive to international investors. As a result, their demands decrease and cause commodity prices to comove negatively with the U.S. dollar exchange rate.

Conversely, commodity prices will climb when the dollar falls. If investors believe that commodity prices are likely to rise over the long-term due to supply and demand trends, and if they are looking for a hedge against the dollar, then commodity indices look like a double play. As prices rise, commodities will attract more investors and speculators, driving up the price even more. Before long, the next financial bubble will grow like the creation of Guiness World Records' winner Sam Sam the Bubble Man.

Disclosure: No positions

Source: Will QE2 Kick Off a Commodities Bubble?