The Phantom Commodity Bull Market and the Consequences

FN: Everybody is talking about commodities and a "new commodity Bull market". The general consensus is that the "China growth story" is responsible for this. Well, yes and no. Chinese demand has indeed picked up, but not because of growth. They're hoarding.

Macro Man explains the Chinese "growth" miracle in The China Syndrome:

"Drilling down beneath the surface, however, we see a picture that is much less unequivocally bullish for commodities. While overall imports have barely started to recover in value terms, many commodity imports have absolutely skyrockjeted in volume terms. And at the end of the day, the inputs to China's industrial and investment complex are based on volume, not value.

Macro Man ran a study looking at the import volume of four different industrial commodities, comparing it with the trend of 2003 through mid-2008, a period in which Chinese growth averaged 11%. (Data for coal imports only begins in December 2004.) The results were remarkable."

(The charts over at Macro Man are mind boggling in their implications. You need to see them for the rest of this post to be in context.)

FN: There is something else to consider as well. PRICES. In a free market economy prices are a signal relied upon by both producers and consumers to adjust their behavior on the margin. This is how both supply and demand constantly adjust in a relentless search for equilibrium. When demand exceeds supply the price adjusts higher. The signal to producers id to increase production and to consumers to reduce consumption. Rising prices therefore NORMALLY signal an expanding economy... in other words GROWTH.

Currently, demand has continued to plummet or stagnate for commodities. However, prices have rallied, with oil hitting $71 a barrel. This price is actually incredibly high if taken in a broader historic context... and even more absurd during times of economic crisis.

The question is, if not demand, what then has driven a bid into commodities?

The economic crisis, while clearly global, has severely stressed the US financial system. It is now feasible that the US dollar will over time lose its reserve currency status. This makes the US dollar less attractive and by extension less valuable. Since commodities are priced in US dollars a weakening dollar is expressed as higher commodity prices.

This was already happening BEFORE the economic crisis hit and was part of the reason oil hit $147 the first time around. However the dollar decline was temporarily interrupted by a safe haven bid when the global economy collapsed. The combination of demand destruction and a suddenly strong dollar crushed commodities, sending oil down to $33.

Since then, demand hasn't recovered and despite massive production cuts oil inventories are at 19 year highs. But the US dollar has started weakening again and more importantly is expected to weaken further in the future. The natural hedge is to buy hard assets.

This of course is nothing new. What is new however, is that the US financial position is now very precarious. Loose fiscal and monetary policies have deployed and most probably completely squandered an absolutely disgusting percentage of the nations true wealth. This coupled with the already well documented demographic problem (health care costs) has made it starkly obvious that the US will indeed face great difficulties honoring these truly monstrous debt obligations in the future.

A very steep yield curve and rising rates on the long end of the curve are already signaling digestion problems. Important holders of US government debt, such as China, have already started to voice their concern. Financing this exponentially growing pile of debt has really become a concern. Rating agencies have even voiced their concern over the golden AAA credit rating of the US.

The only real solution for the US is an eventual de facto PARTIAL default. This would occur in the form of both overt (Fed buying treasuries) and covert (manipulating inflation statistics) fashion. Either way money will get printed and debt will get monetized. The US dollar will fall in value relative to hard assets such as commodities. To complicate matters, it can however, perform quite well versus other fiat currencies. A reduction of the debt burden to a level that is sustainable will suffice and can probably be achieved in an orderly manner.

While rising commodity prices may indeed be signaling the return of some economic stability, they are also signaling something far worse. They are signaling that concerned countries are taking unilateral action to protect the wealth of their citizens by hoarding hard assets.

Ironically higher commodity prices are a form of tax. Recall that when oil first rose above $100 equity markets would actually weaken on days oil moved higher. When prices hit high enough levels, they went from signaling economic strength to signaling an economic problem.

If anything in excess of $100 was a problem when the unemployment rate was 4.5% and credit was easily and cheaply accessible, what is $70 now? The unemployment rate is 9.4% and the financials system is crippled.

Combine that rising interest rates on everything from mortgages to credit cards and you've got yourself a real problem.

The real irony of it all is that higher commodity prices will destroy any "green shoots" that may have sprouted and its all because the desperate bailout of the financial system has so encumbered it that no other outcome is now possible.

Forget about a "V" shaped recovery. Forget a "W". This is going to be an "L" for quite some time.

Think lost decade.

Related Posts:
Green Shoots: Can't Water Them With Expensive Oil
Smashing the 'Perpetually Growing Oil Demand Myth'