Two Moves to Make as the Fed Inflates the Commodities Bubble

U.S. Federal Reserve Chairman Ben S. Bernanke ignored the warnings of most economists last week, and kept the benchmark Federal Funds rate at 2%, far below the actual rate of inflation.

As a result of this non-move, investors can probably look forward to having the global commodities boom continue for at least a while longer.

Here’s why.

Genesis of a Commodities Boom

Although the overall commodities boom has been underway for a number of years, prices didn’t just move up in a straight line: There have been long stretches during which prices advanced sharply, followed by short stretches of volatile prices reversals.

The latest advance - and certainly one of the most intense - was ignited Sept. 18, when the U.S. central bank embarked upon one of the most aggressive rate-cutting campaigns in its history, slashing short-term rates from 5.25% to the current 2.0%. Since the rate cuts began, the Reuters/Jefferies CRB Index of commodity prices has jumped 32%, from 435 to 572. Oil is up from $82 to $143 per barrel, a rise of 74%. And gold has moved rather modestly, from $770 to $928 per ounce, a mere 21%.

The reason for this intense advance in commodity prices is that the Fed and its European counterpart have been pumping money into their respective economies to prevent the collapse of several major banks. The St. Louis Fed’s “Money of Zero Maturity” (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006), is up at an annual rate of 17.6% during the last six months. In Europe, Euro M3 is up at an annual rate of 10.8% during the same period - still double the growth seen in nominal gross domestic product [GDP].

In the key emerging markets, the money supply has been rising even faster - 19% in China over the past year, and 21% in India. Not surprisingly, those countries’ inflation rates are taking off, with India into double digits and China quickly getting there.

Igniting Inflation

In the U.S. economy, inflationary pressures are just beginning to show themselves.  Producer price inflation [PPI] was 7.4% over the 12 months to June. Consumer price inflation rose 0.6% in June - and 7.5% annually - after it previously had been held down by a number of strange-looking “seasonal adjustments.”

But even if the inflation rate is truly only 4%, the Fed’s monetary policy is dangerously inflationary; if it is actually 7%, giving a real Fed Funds interest rate of minus 5%, then prices can be expected to take off like a rocket - as they are already in the commodities market.

Bernanke issued stern warnings before last Wednesday’s meeting of Federal Open Market Committee [FOMC] policymakers, talking about the dangers of inflation and the need to preserve a strong dollar. For the first time, large numbers of mainstream economists echoed his warnings - even Larry Kudlow, one of the strongest proponents of the Fed’s initial rate cuts last September, was spooked by the inflationary prospects.

After the meeting, however, Bernanke did nothing but issue a further warning.

It’s highly unlikely that he’ll raise interest rates before Aug. 5, which is when the Fed next meets. That’s because, having ignored the warning of June’s consumer price index [CPI], Bernanke is unlikely to be pushed into raising rates by a second bad inflation number in July.

In fact, he’s more likely to cut rates than to raise them - but only in the face of a major crisis.

Any “crisis” would probably take the form of a banking collapse, or a serious deterioration in the U.S. economic position, in which case Bernanke might well be forced to cut rates again.

Thus, for the next several weeks, it’s highly likely that the commodities “bubble” - which is clearly what this has become - will grow in both size and scope.

So now that we know that, the question to answer is clear: How do we profit?

Bubbles, Doubles, Oil and Troubles?

It’s fairly clear to me that concerted speculation by hedge funds and pension funds is what’s been pushing up oil prices. But that may be playing out - and reaching its limit - as the huge price increases we’ve seen in “black gold” over the past year are finally dampening consumer spending both here in the United States and in other key markets worldwide. So the oil patch may be too slippery a spot to play right now.

On the gold front, if there is concerted action it is by central banks that are trying to suppress the advance in the price of the so-called “yellow metal.” Unlike oil, there is no natural dampening of demand for gold as the price rises; speculative demand (the major factor) tends to intensify. Moreover, an economic recession, which would probably be accompanied initially by inflation that was still accelerating, could intensify the rise in the price of gold, instead of suppressing it.

Investing in the late stages of a bubble is highly speculative. Nevertheless, I reiterate my prediction of a few months ago that gold will reach $1,500 an ounce. Even if the Fed begins to act against inflation in August, it is very unlikely that its initial actions will be effective. Don’t forget that in the last great inflationary bubble of 1980, gold hit a level that’s the equivalent of $2,300 an ounce in today’s money.

I would consider SPDR Gold Trust (formerly StreetTracks Gold Trust) shares (GLD) about the most efficient way of getting a pure gold play. As an alternative, you might consider a silver investment: The metal is currently trading at less than 15% of its 1980 high, the equivalent of $130 per ounce. If that’s a move you like, the iShares Silver Trust ETF (SLV) seems the best way to play silver directly.

Comments

[PIA]

RIO for Iron Ore + FCX for Copper

[this Bud'sfor you]

The 1980 high was also tainted by the market-cornering attempt of billionaire brothers, Nelson and Bunker Hunt.

[barnburner]

As I remember the Hunt brother's cornering attempt it was after gold went bust and it was only the silver market. Gold made it's last leg up in 1980 due to speculation that the public in the U.S. would rush out and buy gold when it became legal-the citizens yawned, bought no gold and it crashed.

[LarryH]

Very useful article--sound advice.

[DeanPlassaras]

I believe that the main difference between now and 1980 is that then we had a US-centric market versus presently a global market with many more participants, some of which have a cultural affinity to the yellow metal.

[tangos]

It is not true that there is no natural dampening of demand for gold as the price rises. Purchases of gold jewelry in the arab countries as well as India have declined and demand for gold jewelry in developed countries is off as well.

[gabeborenstein]

On September 18 ,2007 ,I was a guest on the Brian Sullivan show (Bloomberg TV) during the FED time.
I have correctly predicted 50 bps FF cut In addition I have forewarned about the debacle to follow. The FED's "aggressive" easing had likely prevented a global implosion that would have dwarfed in magnitude the Great Depression. Inflation is not an issue -but the record leverage speculation is(hedge funds aand others)is.Statistical recession predicted by most (Not Me),had never occured .The stock market has been moving towards new lows anyhow.Please note the record short open interest and one will understand that the market is not a victim of a massive liquidation.
Inflation a problem?not really .In every inflationary cycle the real estate manages to keep up (prices),with the implied rate of inflation.In this cycle the home prices have imploded. Why? again because we are dealing with a mega commodity speculation not a major increase in the final demand(commodities).In the period ahead the commodity prices will implode and adjust for the major decline in the final demand. The U.S economy is alreday turning around but we need to allow for the fiscal and the monetary lag.The FED and the ECB should be easing as mega economic implosion is heading for Europe and the Emerging market economies .Deflation not inflation will become the real issue in the period ahead.

[carey_jim]

As everyone knows, gold and silver were used to back the value of currencies in the past. But this led to the highly irrational policy of countries hoarding gold in places like the famous Fort Knox and determining the value of their currencies by how much of the "precious" metal they held.

Since there was (and is) no way to accurately determine the value of gold, not to mention to completely prevent the dangers that it (Fort Knox) might be destroyed by an act of nature or terrorism, debased by new discoveries and methods of production or confiscated in acts of war, most economists think basing the value of currencies on the amount of gold held by governments is not rational and their consensus was to abandon the gold standard and, if effect, to base the value of the currencies on the underlying value of the economy of each country.

This, of course, is just a long-winded way of saying that most economists don't believe that the value of gold and silver are more stable in value than other commodities.

I think we have to guard against our innate prejudices in favor of gold and silver that are based on historical, literary and even religious grounds.

Gold and silver are good or bad investments for the same reasons other commodities are good or bad investments. We need to examine those reasons and forget our prejudices.

[theinvestingspeculator]

There might be a short-term bubble in some commodities. They could pull back 50% from the highs but stocks suck. The only two good investments right now are Chinese stocks and underpriced commodities like Sugar.

[jt]

jim carrey should stick with comedy, as his little piece of ignorancia shows he hasn't one tiny clue what he's talking about. I'd also recommend that c_j buy up as many FRNs as possible...I'm just SURE they'll turn around (as the Fed is inflating the money supply by nearly 20% annualized now with absolutely NO end in sight, only acceleration 24/7...one of the "stupid" reasons to be on a gold standard, BTW, but I wouldn't want to confuse you with too much truth...and there is NO doubt that that kind of debasement will INCREASE his investment value over time. Have at it jimbo...stash that cash you financial genius!!! The rest of us "prejudiced" and unreasoning fools will continue to trade that green piece of (in reality) nearly worthless funny money for REAL money...gold and silver...as it has been for millenia. Good luck. (PS...hey, I was just thinking, jimmy...I'll bet it'll make really good Monopoly money some day...yeah?...;)

[Skjellifetti]

"It’s fairly clear to me that concerted speculation by hedge funds and pension funds is what’s been pushing up oil prices."

Then perhaps you would be kind enough to explain the mechanism that is making this happen. If there is a bubble, this implies that current supply is greater than current demand at the current spot price and therefore someone must be buying and storing the excess supply. Show me who is buying the excess supply and where they are storing it.

On the other side of the coin, there are a number of factors that have reduced the supplies of many commodities (problems in the Nigerian oilfields, lack of investment in Venezuelan and Mexican fields, power shortages in Chile and South Africa, etc.). At the same time, demand is not falling.

Commodity prices are not being driven by speculators. Simple supply and demand is fully capable of explaining the current high prices. Claims that speculators are driving the prices is a classic example of a wishful thinking logical fallacy. Gosh, if we could just make those evil speculators go away, we could be back in 25 cents per gallon heaven just like in my youth. Better learn to deal with reality, because high prices are going to be around until we can develop alternatives.

[oroloco]

When I'm convinced that commodities are in "oversupply,"... then I'll be convinced that we're in a commodities bubble.

[iThinkBig]

Yes, monetary policy has accelerated speculation directly and indirectly. Indirectly, hoarding is occuring as a hedge, because the world's currency peg the dollar, is barely worth the paper written on, the financial giants acted as dishonest peddlers so investors are buying what is safe and will likely retain value if or when the dollar collapses. Money goes to where it is safest and right now with the U.S. financial system in tatters it's going towards tangibles the global consumer will always need to continue purchasing, mainly food and energy.

The speculators to me aren't the bad guy or boogeyman. I leave that up to our Congress and Senate too busy squabbling over how they can regain losses from the little guy during an election season. The lack of leadership in Washington can be summed up as the top-level reason for the coming global recession and likely collapse of the U.S. financial system based on a failed economic theory (Efficient Market Hyposis).

Russia and the Middle East will likely become the new global financial anchor for a time and that is scary in and of itself.

[blink0404]

Who is exactly is an oil speculator? These big speculators are really using the general publics money to increase the price of oil through managing funds.

The price of oil is partly so high because of the weakening dollar against the euro- it's not all speculation, not all supply and demand.

How much longer will gold go up? watch silver-- when silver peaks, sell gold.
Here's a great article explaining the situation.

www.greenfaucet.com/ha...

[User 30121]

JT: Give 'em hell!

As for this article, I don't see any suggestion to BUY and TAKE PHYSICAL OWNERSHIP of gold and silver...only buying pieces of paper...that are empty promises by cheats and greedy bastards!

Personally, I can't get enough PMs, gold and particularly silver, and I'm doing it via PHYSICAL OWNERSHIP!

[GMiki]

There is no bubble and we're certainly not in the late stages of rising commodity prices. We're in an inflationary period that may quite simply turn into hyperinflation, in which case nothing is more cheering than to have some gold and silver even if it represents a prejudice (a strong persistent prejudice, however).

As for the Middle East, gold jewelry sales are up in Qatar, according to a local article there. Moreover, a gold ETF just opened in Japan. I truly wouldn't count out the overseas markets. In fact, the gold rush hasn't even begun yet.

[azcaballero]

Lets take a look at the gold old days when oil was $0.25/ gallon remember that was when $1 = 1 oz of Silver. As silver is US$18.30/oz it could be supposed that a silver quarter is worth in todays dollars is $4.58 FRN's so gas is still $.25 a gallon.

What does this mean, it means we are at a market price where supply and demand meet at a price that a supplier is happy to trade to a consumer at a price set by the market. The only supply that is increasing is FRN's and thus the reason for this bubble as Skjellifetti correctly suggested is the oversupply of worthless paper driving up the price of real value commodities (things people use to make real things)

Our economic problems today are 100% clearly on the shoulders of our intellectual superiors, the Government and all those brilliant people who set policy and get to spend all the newly created FRN's first. The speculators that are to blame are the ones who print the money and rob us all!

[Eagle-Chief]

Martin - great article, however, I think you are wrong on one point - there is no commodities bubble. What we are experiencing is in reality a DOLLAR CRISIS.

[squashnut]

Great post Jim C. Gold made a great currency in part because it had little use other than ornamental. It still doesn't. Not even used in teeth anymore. Tulips are pretty too.

[eric hart]

Lets be clear in the use our our language so that we can be clear in in our thinking. What is a bubble?

1) Created by cheap and easy credit (many go out borrow much more than they can repay--unless the asset keeps appreciating).

2) takes on the fever of greed--a mania and generally held belief that prices cannot go down--and very little accounting for risk, therefore virtually no fear of collapse.

3) widespread public participation--everyon... wants in.


Apply this to Dutch tulips--credit easy, yep. Widespread greed, absence of fear--yep. Everyone wanted in--definitely.

NASDAQ -1999-2000.
Excessive Margin and easy credit? Yep.
Greed far outpacing fear with belief that stocks always go up in the long run(faith in tech stock investing) Check.
Widespread public participation--check.

Real Estate in US 2001-2007
1) Check (incredibly easy credit)
2) Check (real estate never goes down)
3) Double (very widespread participation)

Japanese Stocks--1989 (nikkei 39,000 to present)
1) Yes
2) Yes
3) Yes

Great-- so now we have some clear examples of bubbles.

Lets run the criteria on commodities:
1) Created by cheap and easy credit (many go out borrow much more than they can repay--unless the asset keeps appreciating).Widely available cheap and easy credit extended to commodities.

Some but not excessive. Many commodities such as the index funds are fully paid to 100%. Futures involve margin, but levels are not out of historical norms.

2) takes on the fever of greed--a mania and generally held belief that prices cannot go down--and very little accounting for risk, therefore virtually no fear of collapse.

Absolutely not. There are people every shorting commodities like the dickens because there is widespread fear and belief that prices must come down. (note how this is the opposite of bubble thinking).

3) Widespread public participation--everyon... wants in.

Not on your life. "Commodities are risky and not for mom and pop." Very few retail investors want anything to do with commodities, or tread carefully with very marginal participation, choosing to allocate a conservative "5% to 10% to their portfolios as a hedge against inflation.

The lesson: everything that goes up is not a bubble. in this case we are seeing the reversal of a 25 year commodity bear market. We are in the first few innings of a commodity bull market.

Its simple really: asset class outperformace alternates with the economic realities. Like earthquakes, the forces at work can happen quickly and leave the landscape utterly different in a very short order.

In this case the earth quake is the treble forces of constrained oil capacity, money supply growth explosion, and globalization contributing to greater middle class consumption worldwide. You may even want to add: political instability, and historical underinvestment in commodity production infrastructure.

We will be in a commodity bubble when people are margined to the hile and mortgaging their homes (whats left of their homes), when you hear the talking heads and the neighbors saying that they just got into soybean futures to fund their retirement because soybeans never go down for goshsakes!

And for the record: the inflation adjusted price of gold is not $2000 something it is actually $4000 something using constant 1980 dollars. The discrepancy results from bogus US government inflation data.

[goldN]

Let's see gold nanoparticles can be used to deliver anti cancer meds directly to the tumors. Gold has various industrial use due it mailable and noncorrosive properties and the jewelry industry is pretty big. Those are just peripheral benefits of gold. Gold is currency. As emerging nations gather wealth, you think they are going to put in US dollars backed by the "faith" of the US government? Takes a lot of faith to invest in a currency that is constantly being debased. They will amass gold.