In 2002, Dr. Ben Bernanke gave a speech discussing his concerns about deflation. He stated, "The U.S. Government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost." He also referenced a statement by Milton Friedman about using a "helicopter drop" of money into the U.S. economy to fight deflation. Well, Bernanke's helicopter has taken off from the tarmac once again. This time, the Quantitative Easing 3 (QE3) flight path is headed, as some commentators have suggested, to "infinity and beyond." It seems to be a route that is growing in popularity as more and more central banks are expanding their balance sheets at record rates. So far this cycle, inflation has been relatively well contained but that may be about to change, at least in the commodity pits.
(click images to enlarge)
By way of background, Chart 1 features U.S. industrial commodity prices since 1850. The green and red arrows above the price indicate the alternation of secular (long-term) bull and bear markets that have taken place since the middle of the nineteenth century. In our recently published book, Investing in the Second Lost Decade, we point out that these very long-term bull and bear trends have averaged 19 and 22 years, respectively. The momentum indicator in the lower panel monitors price movements and triggers sell signals when it peaks (downward red arrows). Obviously, it does not offer precise short term signals, but nevertheless provides valuable clues as to the direction and maturity of the long-term commodity trend. Currently, we are in the eleventh year of the current secular bull market, eight years short of the historical average, and the oscillator is still pointing north. This suggests there is certainly the potential for another up leg. The only question is, when?
The evidence is not yet complete, but things are rapidly falling into place. Chart 2 compares commodity price movements to a momentum series monitoring changes in the velocity of M2 (money and "close substitutes" for money). We know excessive money growth sooner or later finds its way into higher prices, but the trick is being able to time when this happens.
This is where the velocity of circulation comes in. If money is held in bank accounts or under mattresses, it does not have the same influence as it does when it is circulating at a fast clip. The series in Chart 2 takes M2 and makes an adjustment using its velocity of circulation. The raw data is then expressed as the momentum series in the lower window of the chart. It may be possible to debate the theory, but there can be no mistaking the close relationship between this series and business cycle associated trends in commodity prices. In this respect, the solid arrows indicate that upside reversals in the indicator from a sub-zero level typically develop close to primary bear market lows in commodity prices. The three dashed arrows represent failures (starting below the zero line), and you may notice that they all developed under periods when the secular trend was of the trading range or secular bear market variety, not in a secular bull market, as we are currently. Last month, this velocity series bottomed and is clearly warning that a new cyclical bull market may be underway.
Chart 3 offers a simple technique in the form of an 18-month rate of change for commodity prices. The green arrows indicate when the rate of change has reversed from an oversold level, this has typically been associated with a new bull market. Last month it ticked up, but not enough to be confident that a bottom is in place.
The final commodity indicator we will look at is a momentum measure of confidence in the bond market. This is represented in Chart 4 by the blue oscillator, which is calculated from the ratio between good quality government bonds and Moody's BAA corporate bonds. A rising series indicates growing confidence as bond investors shun the safety of governments for the higher (riskier) yields of corporates. It's fairly evident that momentum in the commodity pits is closely related to confidence on bond trading desks. Indeed, in most cases, bond momentum is the leader. Last month, this series ticked up from an extremely overstretched level on the downside. It told us two things. First, bond investors are extremely pessimistic, and second, that a trend towards optimism and inflation may be underway.
We would certainly like to see these indicators move more decisively in an upward direction before concluding beyond a reasonable doubt that commodities had bottomed. In addition, it would be nice to see the CRB Index (529) move more decisively above its 12-month MA at 526. See the latest data here. However, with our Global Gold Index (a commodity leader) at a new high and gold breaking out against bonds, we are giving the commodity secular bull market the benefit of the doubt. This cyclical shift back to the secular bull market for commodities and high inflation has critically important implications for investors, so be on the lookout for our follow up article when our indicators confirm the next cyclical bull market in commodities.