Thursday, February 21, 2008

Pumped Up

This article from The Economist attempts to explain the continued rise in commodity prices, even as economic growth slows:

BANKERS and policymakers may be wringing their hands about the prospects for the world economy, but commodities traders, it seems, see no cause for concern. On Wednesday February 20th the oil price hit a new record of $101.32 a barrel. Soyabeans and platinum, among others, have also reached record prices in the past week. Vale, a Brazilian mining firm, has persuaded some steelmakers to pay as much as 71% more this year for its iron ore. Across the world the inflationary impact is tangible. In America consumer prices in January were up 4.3% on a year-over-year basis. Excluding food and energy, they were up 2.5%, well above the Federal Reserve’s comfort level.

The bull market in commodities is getting a little frothy and most of the reasons advanced in this article, in my opinion, don't answer the question. The answer, as with so many bull markets of recent years, lies in Federal Reserve policy. With China's currency tethered to the dollar, monetary easing in the US has the effect of pumping up demand in China. And that is driving the price of a lot of commodities higher. The article mentions another monetary policy cause at the end:

Nonetheless, the prospects for demand must have diminished at least somewhat as the world economy has slowed, and the outlook for supply has not worsened dramatically in the past few months. Hence some other factor must be at play. Many analysts blame speculation. As falling interest rates, tumbling stockmarkets and contracting house prices drive investors out of bonds, equities and property, the argument runs, there is lots of money looking for a new home. And since commodities have produced such lavish returns in recent years, and have weathered the recent turmoil relatively unscathed, they are an alluring option.

Citigroup believes that the recent rise in the oil price “is driven principally by a sharp uptick in fund flows.” Lombard Street Research sees an “iron bubble”. Others worry that America’s fiscal stimulus may cause trouble by inflating demand for commodities. In Citigroup’s cheery phrase, “the collapse of one bubble often sows the seeds of the next.”

Money flowing out of low yielding assets into higher yielding ones is called disintermediation - a fancy way of saying that individuals chase performance. I wonder how Citigroup will manage to lose money in this bubble...

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