Thursday, May 1, 2008

Commodity fundamentals, commodity speculation

The Economist is ceding (at last!) that loose monetary policy in the US may have something to do with the acceleration of commodity-price inflation, going as far as dropping the b-word!

There is no doubt that commodities have become an increasingly popular investment category — in fact they bear many of the hallmarks of a speculative bubble... The most recent circumstantial evidence also suggests that the Fed may bear some responsibility for the commodities boom. The dollar slipped after the Fed’s rate-cut decision as investors reacted to its doveish tone, though at $1.56 per euro, it was still up 2.6% from its low of $1.60 on April 22nd. The price of oil, after hitting a record high of almost $120 a barrel on Monday, had tumbled to $113 on Wednesday. But the price of crude and other commodities rose afterwards. If those reactions persist, America’s central bankers may have to reflect carefully.

I think that the conflict in this speculation-vs-fundamentals debate lies in (a) the overlap of the (possible) speculative price-increases we've seen over the last few months (sp. since the interest rate cuts in January) on top of a long-term trade driven by fundamentals and which has been in play for several years already; and (b) Jeff Frankel's attribution of the long-term trade to low interest rates also, rather than to fundamentals (as briefly explained in The Economist's article).

Clearly defining the time-horizon one's referring to should deal with most of the confusion arising to the first item. I doubt that most "fundamentalists" can deny that there's been an acceleration over trends over the last few months at the same time as some major economies have been slowing down. And most of us "bubble-heads" agree that there are long-term trades at play and that the really sharp drops in interest rates are fairly recent.

On the other hand, Frankel's arguments will fuel disagreement for as long as there is more than one sentient being willing to have an opinion on the issue. As usual, outside the realm of formal modeling, in which at most one explanation is admissible, reality is likely to be a combination of fundamentals and interest-driven investment/speculative reasons. The question is how much of each.

But since there's more than one sentient being still willing to have an opinion...

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