Explosion Ahead for Commodity Prices?
by: Russell Wasendorf, Sr.

Will Higher Raw Market Prices Fuel Inflation?

Over the past several years, the winds have quietly begun to shift. Not many have noticed. But a shift indeed is occurring. Commodity prices, such as gold and crude oil have pushed higher and attracted attention. Yet other commodity prices have climbed higher with barely a notice. Dairy prices, such as milk and butter have been surging. Soybean futures have skyrocketed to greater than $10 a bushel, hitting their highest level since the summer of 1988. Before the “Mad Cow” scare in late 2003, nearby livestock futures soared to record high levels above a dollar per pound. And early this year, a top most likely was cemented in bond futures prices. But that is just the beginning. A new cycle is on the horizon, and traders ought to begin taking note if their senses haven’t perked up already.

After sitting like a flat tire for several years, the wheels of the U.S. economy are moving forward, and the recovery appears to be firmly in place. There are a number of reasons for this. As of this writing in early May, the economy has pumped out nine consecutive quarters of gross domestic product (GDP) increases. During the last two quarters of 2003, the economy grew at an annualized rate of just more than six percent, the fastest pace in 20 years. The unemployment rate of 5.6 percent is nearly at the level President Clinton (interestingly) bragged about in 1996 as he sought re-election. Household wealth is at an all-time high of nearly $45 trillion. The year 2003 saw economic growth run at a strong pace, and economists agree that the growth outlook remains firm for this year. And despite recent criticisms by a myriad of politicians during this election year, the so-called “misery index” indicates that the U.S. economy (see Table 1), on whole, isn’t as miserable as they say. However, while the economy picks up steam, some longer-term cycles may be ending and others taking shape.


click image for larger view

Case in point – for the past several years, the fear of deflation captured the bond market and the Federal Reserve, but that scare now has retreated into the background. Nonetheless, policymakers and market players may not yet be fully prepared for the next long-term cyclical shifting of the wind, which could usher in some unexpected inflationary surprises over the next three to five years.

For commodity futures traders, this very well could add up to potentially greater volatility on the horizon. Greater volatility, of course, equals opportunity. So, as the financial and commodity markets may be on the verge of a major shake-up, futures traders should prepare for some very unique trading opportunities ahead.

Cycles Act as Basic Guideposts
There is much to be gleaned from looking back at historical market cycles, which in part are responsible for the overall views to be shared in this article. Unquestionably, no theory is perfect, but several offer a beginning point from which to begin framing past market phenomena and to consider future behavior.

Many traders have heard of the “Kondratieff Wave,” an economic cycle discovered by Nikolai D. Kondratieff back in the 1920s. Basically, Kondratieff believed that the world economy moves in 40- to 60-year waves, or cycles, with the average being 52 years and that this economic activity appears to influence practically all stock and commodity prices. His theory proved controversial both then and now, and many economists and traders have discredited Kondratieff’s work, saying it had little or no merit. (In fact, Kondratieff is believed to have died in a Siberian labor camp, punishment for his views of cyclical capitalism.)

But not so fast. The average investor may have misunderstood Kondratieff’s interpretation of how economic cycles work. Looking back to the 1929 U.S. stock market crash, a definite turning point in the economy, and adding 52 years, brings us to1981. Indeed, this year marked the start of a 20-year bull run in U.S. equity prices, but it also signalled a top in inflation and interest rates. Most middle-aged Americans, particularly those borrowing for home loans, remember the scourge of inflation during this period. It was a highly volatile year for the interest rate markets as U.S. Treasury bonds were yielding 16 percent and, from high- to low-yield, T-bill rates whipsawed 22 percentage points in one year. So, not a crash, but certainly a year of extreme upheaval.

Kondratieff’s philosophy, which in retrospect did signal a turning point, was that the free market system is a perfect one if left alone, because it becomes “self-cleansing.” From time to time, it heals itself, and sometimes that healing is painful. The1929 stock market crash may be the best example of an important “cleansing” act for the economy and markets. But every economic cycle is different. In the early 1980s, inflation was the “self-cleansing” act needed at the time.

Yet how much can monetary policy be manipulated before it can no longer be successfully “handled?” When monetary policy is manipulated as much as Greenspan has manipulated ours, it in effect does not allow the capitalist economic system to cleanse itself.

Understand the Tide
Let’s take one more market philosophy that has stood the test of time. Going back to the turn of the 20th century, another well-known market analyst, Charles Dow, invented the “Dow Theory.” In its simplest form, the basic premise of Dow’s theory was that markets move in waves or cycles. The first is a mere ripple, which has no significant impact on long-term market situations. The second is a wave, which creates long-term change, and the third, and most important, is the tide. It is of utmost importance to understand and recognize when the tide is making its appearance because if a trader or an investor can do that, he will be able to discern, so to speak, when all of the boats in the harbor will rise.

What Will the Fed Do?
So, in what direction is the tide now shifting? Economic growth is up, productivity is up, and commodity prices are on the rise. Bond traders are just now beginning to price in some very early concerns about a modest rise in inflation. After hitting roughly a 40-year low at 3.07 percent during the summer of 2003, ten-year yields have skyrocketed to nearly 4.50 percent as of late April 2004. That is likely to be just the beginning of higher interest rates ahead.

The number one question on bond traders’ minds these days must be, “Will the Fed use pre-emptive rate hikes to attempt to forestall a rise in inflation?” The answer is a clear “yes.” In the wake of recent positive U.S. employment reports, Fed watchers are beginning to discuss the possibility of a rate hike even before the presidential election this November. At one point, this was judged to be unlikely, especially as the Fed chairman serves at the pleasure of the President. And once the Fed begins to make moves, interest rates may begin to push steadily forward in rapid-fire moves.


SIDEBAR
------------------------
Remember When?
Those Treasury futures traders who have been around awhile will remember the days when the Thursday afternoon release of the weekly money supply figures was a big deal to the bond market. Yes, bond futures traders would even stick around after the 2:00 p.m. CST close just waiting for those numbers. But no more. Money supply data has faded into the background and has been virtually ignored in recent years.

Maybe people should start paying attention again. In recent years, the Fed specifically honed in on growth targets for the different money measures. Monetary-led expansion still remains an important trick up the sleeve of the Federal Reserve Board governors.

For those who slept through Economics 101, here’s just a brief refresher on the various monetary aggregates. M1 represents the narrowest definition of money supply including currency held by the Fed, Treasury and banks, traveller’s checks and checking accounts. M2 is the aggregate that economists say the Fed watches most closely today; it includes M1, savings and money market deposits and CD’s (less than $100,000.) M3 is considered the broadest definition of U.S. money supply and includes M2, certificates of deposit worth more than $100,000, balances in institutional money funds, repo agreements and eurodollars held by U.S. residents.

Why should anyone care? The bottom line is that over the long term, money growth breeds inflation.
------------------------


Already the Federal Open Market Committee (FOMC), the policy-making arm of the Federal Reserve, has made some noise about lifting the federal funds rate from its 46-year low at one percent. Over the past several years, the FOMC has had an aggressive easing policy, which began in January 2003 when fed funds stood at 6.50 percent. The Fed cut rates 13 times in the last easing cycle into the June 2003 one-percent low. That’s where we stand now.

It’s instructive to look back before the recent baker’s dozen rate cuts to see how past Fed actions may have impacted inflationary woes. There is a fine line between control and balance, and it’s easy to argue that the impact of previous rate increases by the Fed actually created pent-up inflationary pressures. One must wonder if monetary policy in the U.S. has performed well, all things considered. And will Greenspan or his successor be able to control the economy without an inevitable cleansing, wiping the economic slate clean first?

Production Has Suffered
The Fed’s actions, which perhaps have prevented the economy from producing its high level and low level of prices, actually has had an effect on narrowing overall production and output in the U.S. A prime example is lagging raw material production relative to demand. And barring the production increase in soybeans after a year in which production lagged, production in livestock and mining has remained flat. In fact, over the last seven years, there has been no substantial increase in the production of most commodities. And here’s the point: Low prices stymie production.

Consider gold production. It costs $180 to mine and bring just one ounce of gold out of the ground. Obviously, higher market prices spark increased production. If the price of gold or other commodities rises, then producers will be encouraged to produce more, simply because it’s profitable to do so. Absent incentives to do so, they will not.

More Money Going Round and Round
Further, money supply has continued to increase unabated, even when the U.S. economy was shrinking. It is important to remember that in some senses inflation is a relatively new phenomenon. When the U.S. was tied to the gold standard, it limited the government’s ability to create new money and “inflate” the currency. The United States, however, hasn’t been on the gold standard for decades now and, instead, Fed Chairman Greenspan and the FOMC control the nation’s monetary policy and money supply. What many people may not be aware of is that money supply has tripled since Greenspan accepted his post in 1987. In just the last seven years, it has nearly doubled to where it currently stands at almost $10 trillion. [See sidebar “Remember When?” for more information on money supply.]


click image for larger view

One of the many factors behind the jump in money supply recently has been an influx of foreign money: think China, amid massive importing of raw materials by that country. In 2003, the rise in M2 accelerated by roughly 20 percent, up from a 16-percent pace in 2002. Of course, the fact that the Chinese yuan is pegged to the U.S. dollar plays into this as well. Some analysts believe the only way to break this vicious cycle is to de-link the two currencies, which has been a hot topic of late.

The bottom line is that some economists believe that the Federal Reserve and other central banks around the world have been trying to subsequently lower the rate of inflation during each business cycle since 1980. Apparently, they’ve succeeded, as inflation hit a 40-year low in the U.S. last year. The global economy, indeed, saw a secular downtrend in inflation since 1980. But, did it go too far, and what was the cost to the production front? Again, deflation talk ran rampant last year and caused a major shake-up in the bond market but the Fed isn’t talking about deflation any more.

No Getting Around It;Commodities Are Heading Higher
Shifting back to the commodity markets, there are a number of gauges one can look at when examining trends, such as the CRB Index, the Goldman Sachs Commodity Index and the Journal of Commerce index, just to name a few. However, when I first became involved in the commodity markets, I attempted to build my own trading system around an existing commodity index, testing several of the better-known ones as well as several that were more obscure. Unfortunately, none were responsive enough to provide reliable buy-sell signals so, like other traders, I developed my own system by formulating my own index. Although it is an index that I use personally and is not listed for other traders to use, it makes the case that inflation is on its way in spades.

Take a look at the Wasendorf Composite Index of 21 of the most widely used raw materials (purposely excludes energy and gold as these generally are broader indicators of world economics) in Chart 1. The index, including the food markets, food and fiber, grains markets and strategic and industrial metals, set an all-time record high at 184 in December 1980. Amidst current low interest rates and inflation, this index has been surging over the past two years and is now at 135. Seemingly out of nowhere, it began to sneak upward.

The more public and closely watched CRB (Commodity Research Bureau) commodity index, also has exhibited a sharp rally. The index dropped to a low at about 182.00 in October 2001 and has posted a virtual straight ascent into the March 2004 peak at around 285.00 (that rally took out the 1988 high at 272.00).

Pervasive Rise in Commodities
But what is significant in these rises? Simply, it is that in several different commodity indexes the price increases are pervasive and broad-based; it is not a solo commodity or even a singular sector that is driving major commodity indexes higher. This is what underscores the significance and warning signals regarding future inflation.

The link between commodity prices and inflation are indisputable. As everyone knows, inflation exists when a consumer’s money buys less, and though inflation currently is low, we are on the verge of a massive wave of inflation. The Wasendorf Composite index is set to continue its recent rally and soar sharply higher. So, too, will the CRB and GSCI (Goldman Sachs Commodity Index), and other indexes meant to measure commodity prices.

It also is highly likely that, as things fall into place, Treasury bond and note prices will continue to fall sharply, resulting in a massive increase in long-term rates.

Fuel for the Commodity Boom
Many economists agree that the stage is set for a continuing rise in commodity prices, in all likelihood higher than inflation, over the next several years. Any discussion of commodity price increases and potential inflation would not be complete without an exclamation point connected to China. Explosive growth is occurring in that country, with first quarter gross domestic product surging 9.7 percent this year. Economists point to the country’s insatiable demand for raw materials as a major boon to U.S. exporters; the Chinese have been huge importers of such commodities as crude oil, cotton and soybeans, to name but a few.

As an enormous demand force in our current global market environment, China will support a continuing rally in the commodity markets, even as their economy shows signs of overheating. Despite concerns of inflation within China, economists expect growth to remain robust. The Conference Board forecasts economic growth in China to be in the neighborhood of 10 to 12 percent this year. With China as home to the world’s largest population at 1.3 billion, with an extremely productive work force (in March, their industrial production was almost 20 percent higher than a year earlier), it’s a potent force for commodity consumption. No wonder then that this population is hungry for the kind of lifestyle, goods and services that Americans have enjoyed for years. There is little chance of this abating.

China Already May Be Overheating
Signs of consumer inflation, however, are emerging on the global level, economists warn, with the Chinese data waving red warning flags. In the U.S., raw material costs are a small portion of overall total costs of a finished good; it is labor costs have a much larger impact. The same is not true for China; in fact, it is the inverse of America’s equation. Chinese labor costs for finished goods are minimal, while raw material costs take on a greater importance. In a developing country such as China where many workers live at subsistence levels, a rise in basic costs such as food hits home hard and fast.

In recent months, industrial prices in China have risen along with those price rises in the U.S. (because the yuan is pegged to the U.S. dollar), which has contributed to inflation for Chinese supplies to the U.S., analysts at the Economic Cycle Research Institute note. Following this jump, inflation at the consumer level has surged in China. Recent data reveal a rising trend in the Chinese consumer price index over the last year. Chinese manufacturers will be forced to raise wages for their domestic labor force to cover the rising costs of food and other commodities. Everywhere one looks, the reality of higher prices is seen. It’s a vicious cycle stemming from many factors, but once it takes hold of a global market cycle, it is very difficult to break.

China’s Insatiable Appetite Should Continue
Statistics show that China contributed a mere four percent to total world GDP in 2003. Yet, its consumption of raw materials far outpaces its GDP output as the country takes advantage of cheap labor to manufacture goods for the rest of the world and for its more consumer-conscious population. These are unquestionably big numbers. Overall, in 2003, China’s insatiable appetite for raw materials resulted in 21-, 31-, 25- and 40-percent of world consumption of steel, coal, aluminium and cement, respectively.

Let’s assume that China remains on its current growth track toward a higher standard of living. This ultimately will result in continued strong demand for raw materials, including crude oil. In the last decade, China has shifted from being a net exporter of oil to a net importer. Demand for base metals, including copper, has been strong from China as a higher living standard creates demand for commodities related to construction of new housing.

Additionally, not just in China, but globally, demand has already been increasing for livestock, and as emerging country diets continue to shift toward meat protein, this trend should continue. Actually, this began back in the early 1970s, when Japan began importing feed grains to support their desire for more meat. In fact, in July 1973, soybean prices reached an all-time high of $12.90 a bushel as worldwide demand outpaced a dwindling supply. As more and more countries act on their citizens’ desires, demand will increase further.

Production Capacity Not Keeping Up
Thus, another factor worthy of consideration in viewing future inflation fears is that in light of the increased commodity demand, production capacity has not been able to keep up. While grain production has been rising in recent years, demand is rising at a faster pace. According to the Department of Agriculture, global carryover of wheat supplies, for example, has been declining in recent years; carryover wheat supplies stood at about 80 days in 2003, compared to 140 days in 1986.

All aspects surrounding commodities, including demand, lack of production capacity, insufficient storage and delivery capabilities will feed into the rising price cycle. International shipping costs are on the rise, and some of that will be absorbed before it hits the consumer’s pocketbook, but not all of it. A recent Journal of Commerce story, for example, highlighted the shortage of containers that has resulted in higher costs for trans-Pacific carriers and shippers.

Higher Commodity Prices Are Already Hitting U.S. Consumers
Bringing this issue back home, price increases already have become evident throughout the U.S. economy, and producers have been passing along prices to consumers. Take a look at just one commodity that affects nearly everyone. Gasoline...up 15 percent in the past nine months.

Crude oil prices, though they have danced up and down somewhat, are currently at or near record highs. Nearby crude oil futures exceeded $40 per barrel in early May, by historical standards extremely high. Early in 2003, just ahead of the U.S. invasion of Iraq, nearby crude hit $39.99, but prior to that, prices hadn’t been at such lofty levels since the 1990 invasion of Kuwait sparked a rally to the $41.15 area. A more normal high price level for crude oil would be $25 per barrel.


SIDEBAR
------------------------
JOC - ECRI Index Posts Sharp Annual Jump
All the well-known commodity indexes are hinting that inflation is on the horizon. Commodity traders have long watched the JOC index for early clues on the direction of inflation. The Journal of Commerce - Economic Cycle Research Institute (JOC - ECRI) Industrial Price Index was developed as a leading cyclical indicator of the inflation cycle. This index is believed to anticipate turns in consumer inflation and has shown a sharp annual jump.

As of late April, this index stood at 114.6, a whopping 30.6-percent annual change over the previous 12 months. The petro sector has led the advance at a 61-percent gain over the last year, while the metals component has surged 43 percent in the same time period.
------------------------


Unleaded gasoline, as a product of crude oil, has taken it on the chin as well, and consumers have noticed a major difference at the pump. The U.S. Energy Department in May forecast that the national average price would peak in June at $2.03 and remain high throughout the summer. In many areas of the country, of course, gas prices are already higher than that, and consumers are taking notice.

Yet, they are still driving the same amount and haven’t stopped buying gas-guzzling SUVs. A recent Energy Information Administration (EIA) report, released in April pointed out the higher gas prices won’t be keeping people at home this summer. Instead, the EIA said the number of drivers and the amount of fuel used will continue to post an increase this year, and summer demand for gasoline is expected at 9.32 million barrels per day, a record-high level.

It’s not just gasoline. Food prices are surging as well. As of March, food prices had jumped 5.3 percent year-over-year, according to the Department of Agriculture. People still have to eat; yet over the past 12 months, egg prices have skyrockted 33 percent, beef prices have jumped 13 percent, and chocolate prices have surged to a 17-year high. Since the beginning of 2004, wholesale dairy prices have doubled, and some of those increases have been passed along to consumers. Yet, consumers are not going to give up drinking milk, eating cheese or enjoying their scrambled eggs. They will pay the higher prices. The current U.S. demand structure is still insatiable, and price is not yet a factor.

Rising prices are everywhere, and after some years of food processors absorbing price increases, they finally are being passed on to the consumer. Even Starbucks officials have been starting to wring their hands over higher dairy prices. While no official price increases have been announced, the company has warned that if the jump in milk prices continues, customers’ lattes may cost even more.

Consumer Inflation Remains Low in the U.S. for Now…
Looking at the data, however, current inflation readings remain extremely low, after hitting a 40-year low late last year. The latest data, as of March, revealed the producer price index had a modest 1.4 percent year-over-year increase. While the consumer price index posted a 1.7 percent year-over-year increase in March, one can’t ignore the sharp jump in raw material prices that has been occurring.

Ultimately, some economists believe that higher raw material prices ultimately result in higher prices for finished goods. The numbers are worrisome. Just look at the price of steel: a 30-percent jump in 2003. Iron ore prices surged 36 percent, aluminium up 36 percent, copper up 15 percent, and the list goes on. Inflation, at the consumer level, has not yet come into play, but it will.

More Inflation Still Ahead
It’s not just rising commodity prices that warn of imminent inflation down the road. In addition to commodity prices headed upward at a fast clip, economists point to growing money supply, higher real estate prices, slower supplier deliveries and higher import prices as additional signs of inflation in the pipeline. In fact, the Economic Cycle Research Institute’s future inflation gauge jumped from -2.2 percent to 3.3 percent in March of this year. According to the Institute, this suggests that a cyclical upturn in inflation is anywhere from two to four quarters away.

Everything goes in cycles. The business economic cycle shifts from recession to expansion and back. Stock prices move up in bull markets and down in bear markets. Mortgage prices cycle higher and lower, just as we saw with last summer’s multi-decade historic lows, refinancings and new home purchases.

Inflation runs in cycles too. The last major peak in inflation occurred in the early 1980s. The signs are cropping up that the inflationary cycle is preparing for another upswing. Just take a look at the gold market. After years of hibernation, many called gold a “dead” market; yet the yellow metal has been surging higher over past months. While there are several reasons behind the rally in gold prices, inflation is certainly one of them. The gold market historically has been a hedge against inflation in paper currency.

Gold futures hit their highest level since 1988 earlier this year, rallying above the $425 mark. While prices have pulled back in a “corrective” type of retreat off those highs, many gold bugs believe the long-term bear has simply come out of hibernation, and gold still has significantly more upside to come in the months ahead. As evidence of inflation continues to rear its head in various sectors of the economy, it likely will support additional gains in the gold market because individuals invest in gold as a way to protect their paper assets from value erosion.

Everything goes in cycles. Even inflation. Remember back…the Consumer Price Index edged above 13 percent in 1980.

Bonds Set to Resume Normal Relationship with Commodities
At this point, one is smart to ask: but what about bonds? Normally, inflation-conscious bond traders zero in on commodity price movements closely. There was a time when floor traders would bid and offer T-bond futures tick for tick against movements in the CRB index.

Historically, rising commodity prices have been a negative factor for the bond market. Why? -- simply because that inflation eats away at the value of fixed income instruments.

But in recent years, Treasury bond futures staged one of the greatest bull markets of all time, which tugged long-term yields to multi-decade lows, while commodity prices were rising. The normal inverse correlation between commodity prices and bond prices disappeared. Why? For one reason, after the U.S. stock market bubble burst, American investors flocked to the bond market as a flight to quality. Millions of investors pulled cash from mutual funds and stock accounts and dumped it into money market accounts and Treasury coupons for safekeeping.

But it’s likely that the “normal” historical relationship between commodity prices and Treasury bonds is about to reassert itself. Many analysts are beginning to acknowledge that the Treasury market bull has turned into a bear and believe that severely weak long-term bond prices are ahead. Some analysts are beginning to target a move in the ten-year yield above the five-percent area later this year or early next, with additional upside yield targets in the range of 5.50 to 5.75 percent for 2005. This is clearly within reach over that time period and may be conservative, given the risks that inflation is posing. Also, as a result of the inflation on the horizon, the U.S. yield curve is likely to invert.

Greenspan’s Surprise
Looking ahead, the Fed Chairman may be facing sharply rising inflation with which he may be ill-prepared to cope. This will occur as demand from consumers and for raw materials remains strong and more money chases fewer goods. The bond market, though it received a sucker punch from Greenspan earlier this year, generally has faith that the Fed chairman will be able to control inflation. But sometimes underlying market forces and economic cycles are larger than a group of economists sitting around a boardroom table in Washington, D.C., and this may be one of those times. This time around, underlying market forces may be setting up to drive inflation significantly higher. The Fed can only do so much.

Look at history. Learn from history. Study your charts. While paper assets, including stocks and bonds were favored over the last 20 years, perhaps the shift back to “hard” assets or commodities is now beginning. Take the time to consider that commodity futures, as an asset class, will react positively to inflation unlike the stock and bond market, which likely will interpret an unexpected high dosage of inflation as bad news.

Huge inflation is ahead, and Greenspan can’t stop it. This is the type of market environment that will offer traders volatility. Get ready for opportunity and volatility in the commodity markets.