commodity prices to go up with a lag

This blog was published first at www.hardnewsmedia.com on October 4th, 2008

Future gazing: Commodity prices to go up again???

One thing is for certain in this uncertain world hereafter… Life will be different for at least the next one year and the world will be in a state of flux as long standing assumptions and bedrocks of stability are overturned by market forces. The chain of events which has been set in motion by the exploding real estate crisis in the USA will have a global impact in many known and in many unknown ways. The pendulum has swung decisively in the direction of fear and it will take some time before the direction is reversed and greed manifests itself once again to complete the cycle of greed and fear.

Inspite of the estimated $700bn that Iraq war was costing the government of USA, the Federal Reserve still had an estimated war chest close to $800bn before the recent unraveling of the American banking system. Vast amount of liquidity was being pumped into the global financial system by continuous issues from the US treasury and the subscribers to these notes were the cash rich governments of China and the Middle East. In effect, USA’s war efforts were being funded by these countries as the Bush administration managed to turn the surpluses of Clinton era into massive deficits which have characterized the Bush era.

We are now faced with a budget deficit in USA of approximately $475bn for 2008 to which will be added the $85bn bail out of AIG, the $200bn bail out of Freddie Mac and Fannie Mae, the October 2nd $700bn bailout package and God knows how many more bailouts which the US government will be forced to engineer. And these numbers do not even include the measures being deployed to ensure that liquidity remain in the system and tightening of credit enhanced by growing counterparty risks do not end up completely drying the availability of credit in the system. It is clear that the treasury is committing more than what it has and printing notes to support the collapsing US government institutions. For the moment the support for dollar comes from the flight to safety which has prompted treasury yields dipping to record lows as growing risk aversion force investors to flee to the relative safety of bills backed by US government guarantee.

However, it is a matter of time as dust settles and investors start adding up the numbers and the numbers just do not add up in support of the US dollar. With the economy tanking and recessionary conditions looming large (assuming we are not already in recession in USA), it is not difficult to imagine that interest rate cuts to revive the economy will be soon on the cards.

While the government will attempt verbal plays to shore up the dollar and prevent a flight out of the dollar, funnily enough a falling US dollar will be a boost to the only bright spot in the US economy, namely the export sector. It is the exports out of USA, aided by a falling dollar, which had kept the manufacturing sector humming over the last year or so inspite of the huge run up in the price of Oil.

A dollar collapse will once again trigger a run up in the prices of commodities, most of which are traded in US dollars and rise in tandem with a fall in US dollar in order to preserve the price to producers in real terms. True, that there is a slowdown in the fast growing economies of China and India which were blamed for an increasing demand for Oil. But the call you have to take is whether the slowdown in China and India and elsewhere would be enough to slowdown the demand for commodities.

The trillion dollar question is whether the demand slowdown resulting from slowing economies will be enough to negate the impact of a falling dollar. Compounding the calculations is the strong multiplier affect which is now exerted by hedge funds which tend to jump in to chase momentum magnify the movements in prices in either directions. Commodity focused hedge funds have had a good year inspite of the battering taken by them over the last few months and are still a force to reckon with. I am sure they are their watching the scenario play out and waiting to pounce on the currency movements. A slowing economy with rising commodity prices may just be the wrong prescription doctor ordered and may lead to a lingering health crisis for the markets in the short run. It will require bravery to bet on a continuing fall in commodity prices in view of the worsening scenario for US dollar. Expect an eventual fall in US dollar to lead to a reversal in falling prices of commodities .

Atim Kabra (hiatta5@yahoo.com)