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Stock Markets Ignore Soaring Commodity Prices

By Tuesday, 08 February 2011 09:06 AM Current | Bio | Archive

During the past three trading days, we have seen generally unexpected moves in many of the major currencies like the euro, the British pound and the dollar.

Looking somewhat deeper into what caused these moves, we detect there was surprisingly a real consistency to what was moving them.

Whether it was euro, the British pound or the dollar, the primary focus remained very much on the likely path of the respective monetary policies.

For the eurozone it was the seemingly, but nevertheless really dovish tone of ECB President Jean-Claude Trichet’s remarks on Thursday, Feb. 3, notwithstanding euro area annual inflation came in at 2.4 percent in January 2011 well above the EU “Maastricht” well-defined target of 2 percent.

For the U.K., the focus was on the growing minority on the Monetary Policy Committee (MPC) that now seems increasingly prepared to vote for policy tightening.

For the dollar, it was the unemployment rate number unexpectedly falling to 9 percent from 9.4 percent the previous month on Friday, notwithstanding payroll jobs were disappointingly anemic with private service-providing jobs only rising 32,000 after a 146,000 increase in December.

These three occurrences seem to have proved critical in shifting perceptions over where the Fed funds target rate probably could be set by the end of this year.

That this should be the case is entirely consistent with what has become one of the defining characteristics of the past eight months, which is raising concerns over commodity price inflation.

It’s also a fact that over more or less the same period, equity markets have performed very well since the start of June 2010 with, for example, the Dow Jones Industrial Average up around 19 percent while U.S. headline inflation has been continuing to run at levels that are tending to remind us of the early 1960s. Cynics could even state it must seem odd to a U.S.-based investor that anyone should be concerned about inflation.

Putting that aside, we all know that over the course of the same time span, the Commodity Research Bureau (CRB) index has gained over 36 percent while the price of corn has doubled. Putting these numbers into context then, we see that the only other times when the CRB has showed similar gains was in the summer and early autumn of 1973 and the period running up to the early summer of 2008. Also, the only time that corn prices have risen like this was in the period running up to the summer of 2008.

When looking back to all this, while admitting we certainly could debate about the transmission mechanisms, it is nevertheless difficult not to make a reasonably direct connection between these moves and perceptions about both the likely direction of U.S. monetary policy and the dollar itself.

Everybody can see that the recent rally in the CRB index has coincided almost exactly with the renewed downtrend that emerged in the dollar index since mid-2010 and that this has coincided with shifting perceptions over the likely direction of U.S. monetary policy.

Investors should take notice that this is also entirely consistent with the forces that drove the previous two great bursts of commodity price inflation.

Back in 1973, it was President Richard Nixon’s decision on Feb. 12 to devalue the dollar by a further 10 percent by reducing the gold content of the dollar another 10 percent to 11.368 grains (one troy ounce of gold contains 480 grains) after reducing it first to 12.63 grains on March 31, 1972. (The devaluations in terms of gold were pro forma only as President Nixon had already closed the “Gold Window” on Aug. 15, 1971 when he unilaterally canceled the direct convertibility of the dollar to gold).

The subsequent move thereafter was in March 1973 when the major currencies were allowed to float against each other and it was that historical event that provided the catalyst for the flight into commodities and logically also in gold with its price culminating in January 1980 at $850 an ounce, as investors piled into bullion because of high inflation due to strong oil prices, the Soviet intervention in Afghanistan and the impact of the Iranian revolution.

In 2007 and 2008, it was the FOMC’s aggressive quantitative easing policy that provided the vital spark.

Of course, none of this is to say that I necessarily consider U.S. monetary policy settings to be particularly inappropriate. After all, it’s difficult to argue with Fed Chairman Ben Bernanke when he stated last week: “I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries. It’s really up to emerging markets to find appropriate tools to balance their own growth.”

With “official” year on year CPI in China running at 4.5 percent in China, China's Central Bank (PBOC) raised its benchmark one-year deposit and one-year lending rate by another 25 basis points to 3 percent and 6.06 percent respectively, which is its second increase in only just over six weeks and the third time since October 2010.

It clearly makes fighting inflation one of its top priorities for the new year.

It is easy to make the argument, in accordance to Mr. Bernanke, that it is the U.S. that it is getting it right and that also more dollar weakness could “normally," which doesn’t necessarily mean that it will, be expected and that in fact it will be up to the “emerging market” nations that have been behind the curve.

All that said, there is, unfortunately, another observation that needs to be taken into account and that’s about the outcome of the great commodity price booms over 1973 and 2007/2008.

Investors should take notice that these great commodity booms were followed by two of the most vicious bear markets in equities in the past 50 years.

The 1973 bear market, which actually started at the end of January 1973, saw the DJIA collapse by 44 percent over a 22-month period with the biggest losses coming after the Yom Kippur war and subsequent oil embargo of October 1973.

Similarly, the first signs of the 2007/2008 bear market emerged quite early in October 2007 but the biggest losses came thereafter in the aftermath of a hugely aggressive rise in commodity prices, which was after May 2008. Overall, the DJIA lost 54 percent in 18 months between October 2007 and March 2009.

Nevertheless, so far, the good news remains that equity markets have shown little in the way of a negative response to the price movements seen in commodities.

Bottom line: Investors should be on watch and certainly not be complacent as all this suggest the potential for a further complicating factor in the story of the past three years that could easily surprise a lot of investors.

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During the past three trading days, we have seen generally unexpected moves in many of the major currencies like the euro, the British pound and the dollar. Looking somewhat deeper into what caused these moves, we detect there was surprisingly a real consistency to what...
Tuesday, 08 February 2011 09:06 AM
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