Commodities: One Day At A Time For The U.S. Federal Reserve

Summary

• The April meeting provided no forward guidance.
• GDP fell by 4.8% in Q1.
• Unemployment is over 30 million and climbing.
• The Fed has unlimited liquidity and is ready to use it.
• Inflation in 2021-2022 is on the horizon- Scale-down accumulation of commodity assets.
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The US Federal Reserve is the leading central bank in the world. In 2008, the Fed cut interest rates to zero and developed quantitative easing to stimulate the global economy and avoid economic disaster. Other central banks followed with policies that encouraged borrowing and spending and inhibited saving. The wave of liquidity that followed the 2008 crisis led to a bull market in commodities that took prices to multiyear, and in some cases, record highs in 2011.

Twelve years later, after increasing rates from zero percent and reducing its balance sheet, the outbreak of Coronavirus caused the Fed to unleash a more substantial tidal wave of liquidity on markets. Short-term rates in the US are back at zero, and the central banks are pushing quantitative easing to new and unprecedented levels. The price tag for the global pandemic will be massive in the years to come. The initial impact on commodity prices is much the same as in 2008 as a deflationary spiral hit many members of the asset class. The actions of the central bank could set the stage for another period of price appreciation in the raw material markets in the months and years ahead. The Invesco DB Commodity Index Tracking Fund (NYSEARCA:DBC) holds a diversified portfolio of commodity futures contracts. On April 23, in an article on Seeking Alpha, I explain how the significant weighting of the DBC EETF product to energy pushed the price lower and that the price action in crude oil was a warning for all ETF/ETN products. However, DBC has exposure to a diversified portfolio of commodities including energy products. The path of monetary policy is supportive for raw material prices in the long run.

The April meeting provided no forward guidance

Last week, the Federal Open Market Committee conducted its April meeting under social distancing guidelines. The Fed left interest rates unchanged at the zero to 25 basis point level. In its statement, the central banks said it remained committed to providing liquidity as needed. In his press conference, Chairman Jerome Powell stressed that this is a time when Congress needs to use the “great” financial power of the United States. The Chairman and committee provided no forward guidance. The message from the central bank was vague and open-ended, given the uncertainty surrounding the continued impact of the global pandemic on the United States and global economies.

GDP fell by 4.8% in Q1

Last week, the Bureau of Economic Analysis reported that first-quarter US GDP fell by 4.8% compared to consensus estimates of a 3.5% decline. The contract was the first since the first quarter of 2014. While the drop was not as bad as the worst declines during the 2008 financial crisis, the full impact of Coronavirus on the US economy may not emerge in the data until the Bureau releases Q2 data.

The most significant problems with the economy over the first three months of this year came from consumer spending, nonresidential fixed investment, exports, and inventories. Consumer spending accounts for 67% of total GDP, and it fell 7.6% in the first quarter. Durable goods spending fell 16.1%, and expenditures for services were 10.2% lower. Exports fell by 8.7%, and imports were 15.3% lower. Many analysts expect the 4.8% number to be revised downward and Q2 to be far worse. JP Morgan analysts project a 40% decline in Q2.

Unemployment is over 30 million and climbing

Before the self-induced coma in the US economy, unemployment was at its lowest level since the 1960s. Last week another 3.8 million people in the US applied for first-time unemployment benefits bring the total to over 30 million since mid-March.

This week, the US Labor Department will report on April jobs, and expectations are for a loss of 21.3 million that would send the unemployment rate to 16%. The markets are bracing for the worst in history.

The Fed has unlimited liquidity and is ready to use it

The longer parts of the economy remained closed, the worse the economic data will become. We are now in the midst of the Q1 earnings reports from companies, but the full impact of the crisis will not arrive until the summer with the Q2 reports. EPS will become LPS or losses per share.

At the April Fed meeting, Chairman Powell told the world the central bank has the unlimited liquidity available and is prepared to use it as needed.

Economic contraction, job losses, and a prolonged period of double-digit unemployment are going to continue throughout 2020 and perhaps into 2021. Short-term rates are not going to rise any time in the foreseeable future, and the quantitative easing program will continue to expand. At the same time, the “great” fiscal power of the US government will continue to assist businesses that are on the brink of bankruptcy. The companies that are essential to national security will receive unprecedented levels of capital until stability returns to the markets. Leading airlines, energy producers, and other businesses will survive as they are too important to fail. “Too big to fail” was a moniker of the 2008 financial crisis. COVID-19 will give birth to “too important to fail.” Stimulus has taken on a new meaning in 2020, and its price will weigh on markets over the coming years.

Unlimited liquidity from the Fed, bailouts, and helicopter money from the government and other programs helping companies and individuals weigh on the value of the dollar and are inflationary in the long term. Increasing the money supply comes at a cost.

From 2008 through 2011, commodity prices displayed a boomerang effect. In the years ahead, expect the same type of reaction from the raw materials asset class.

Inflation in 2021-2022 is on the horizon- Scale-down accumulation of commodity assets

Crude oil traded to a low of $32.48 in 2008; by 2011, the price was over $110 per barrel. Copper fell to a low of $1.2475 in December 2008. In 2011, the red metal reached a record level of $4.6495 per pound. Gold reached $681 and silver $8.40 per ounce in 2008. In 2011, they traded to peaks of $1920.70 and $49.82, respectively. Soybeans reached $7.7625 and corn $2.90 per bushel in 2008. The oilseed and grain traded to $17.9475 and $8.4375 per bushel in 2012. Sugar futures fell to 9.44 cents in 2008 and reached a high of 36.08 cents per pound in 2011. Many other commodities that fell to lows during the 2008 deflationary spiral experienced a boomerang effect during the following years. If history repeats, the unprecedented tidal wave of stimulus in 2020 will have a similar impact.

The fund summary and top holdings of the Invesco DB Commodity Index Tracking Fund (DBC) include:

Source: Yahoo Finance

DBC has net assets of $779.2 million, trades an average of over 1.77 million shares each day, and charges a 0.85% expense ratio.

Source: Barchart

DBC reached a low of $17.94 in March 2009 and rallied to a high of $32.02 per share in 2011. Markets are far from out of the woods when it comes to the impact of the global pandemic. The Fed’s pledge to do everything in its vast power to provide liquidity and government stimulus programs is inflationary for the future. DBC was trading at just over $11 per share on Tuesday, May 5. The ETF was just 59 cents above its all-time low. While it may move even lower, the odds of an explosive rally rise with each injection of liquidity that increases the money supply. I would be a scale-down buyer of the DBC ETF product. Contango or forward premiums for futures contracts eat away at the value of the product over time. An explosive rally that reflects the current course of monetary and fiscal policies in the US and around the world has the potential to erase the contango losses and deliver a spectacular return over the coming months and years. The current wave of deflationary pressures will cause commodity production to decline and could lead to shortages as inventories fall. While I wrote about the potential dangers of commodity ETF/ETN products on April 13, the low price of DBC is attractive based central bank and government monetary and fiscal policies.

It may be one day at a time for the monetary policy of the US Fed, but each day the central bank increases the money supply makes the chances of an inflationary whiplash that much higher.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.