Two Moves to Make as the Fed Inflates the Commodities Bubble

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Includes: GLD, SLV
by: Martin Hutchinson

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 (NYSEARCA: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 (NYSEARCA:SLV) seems the best way to play silver directly.