Friday, April 18, 2008

What's driving commodities

Commodities are a particularly interesting corner of the financial world right now because of the way food and oil have been making headline news over the past 3 months. There's lots of Malthusian talk about supply and demand and China and the limits of growth, some of which may even be right. At the same time, I find the evidence increasingly convincing that a lot of the recent movements in commodity prices are due to much shorter-term factors, namely negative real interest rates. Econbrowser puts it in the simplest terms, and proposes (with the help of the Fed) a test of the hypothesis.
I nevertheless am not persuaded that any of these news items is the primary explanation for the recent highs in oil prices.

The reason is that we're seeing similar increases since the start of the year in the price of virtually every storable commodity. The 12% increase in oil prices this year is in fact just the median for the group of 15 commodities graphed below. It seems to me we should be looking for a single explanation behind the common behavior of the group, rather than try to develop a separate theory for aluminum, barley, coffee, cocoa, copper, corn, cotton, gold, lead, oats, oil, silver, tin, and wheat.

Instead I believe that the price of oil, like the price of all the other storable commodities, and for that matter the dollar cost of a euro, is primarily responding to the Fed's decision to move the real interest rate strongly into negative territory.

But once again the Fed has a golden opportunity to prove me wrong. Fed funds futures prices currently reflect an expectation that the Fed will make one more cut to 2% at the meeting at the end of this month, and then stay there. Here's a prediction for you. If the Fed surprises the markets by holding steady at 2.25%, all those commodities will begin to crash within hours of the news.

I might also add that this speaks to a question I have been pondering: where can macro level thinking can add some value for an investor. Financial markets are complicated places. You do you homework and you invest your money, and even when you get it right, you are not necessarily sure why; were you a genius or were you simply lucky? Considering some of these macro issues helps you to sort out whether there was some underlying force you benefited from yet remained unaware of.

No comments: