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Tags: Falling | Commodity | Prices

Falling Commodity Prices Will Soften Recession

By    |   Wednesday, 12 March 2008 02:58 PM

One bubble after another seems to be striking America.

The first great bubble, perhaps the largest in human history up to that time, was the dot-com bubble.

It popped in 2000.

The dot-com bubble was followed by the housing bubble. In 2005, The Economist magazine called that bubble "the biggest bubble in history."

"Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000," The Economist stated. "What if the housing boom now turns to bust?

"Pain," the magazine predicted.

The Economist was not alone in soberly surveying the landscape.

When I visited Sir John Templeton in the Bahamas around the beginning of 2005, he also saw that bubble bursting.

At the time, he told me that we would see in some markets 50 percent price declines which would wreak havoc across the financial systems. His comments seemed simply unbelievable.

This week Wilbur Ross, the brilliant financier, told CNBC he was perplexed why every one fears a recession. Recessions might not be a happy event, but they are natural to the business cycle. And they also cure economic excesses.

Let's suppose you never wanted a cold? It would be a nice desire but not very likely or even healthy in the long run.

Minor colds may actually be good things. They are temporary events that defeat disease while your body learns how to defuse them and worse diseases. Every bad cold makes your immune system stronger.

This metaphor has applied well since the World War II. Every recession has been temporary and has helped to create the conditions for the next great boom.

The simmering recession we face may already be helping as it will soon snuff out an ancillary bubble that is crippling the U.S. economy, namely, the commodity boom.

I tend to agree with Jim Rogers, who has argued that a long-term bull market in commodities is underway. The growth of emerging markets like China, India and Brazil will help fuel the demand for raw materials for years to come.

But, like equities, even commodities can be "talked up" and prone to speculative excess.

To understand why commodities are way overpriced, we first need to understand the primary cause of commodity price increases.

The big media has finally started reporting that surging commodity prices are due to a devaluating dollar.

BusinessWeek recently reported: "Analysts say the falling value of the U.S. dollar combined with tight supplies across many commodity markets has fueled the big run up."

And, on Monday, NBC Nightly News pointed out that oil prices — now nearing $110 a barrel — are rising due largely to the weakening dollar.

Nice to hear that the major media are finally reporting what Financial Intelligence Report and MoneyNews have been telling readers since 2004, namely that a devaluing dollar was in turn driving up commodity prices for Americans.

For example, in terms of constant 2000 euros, oil is selling to Europeans at a cost of just $70 per barrel, as compared to the $107 that Americans are paying for oil. It is no surprise that headlines about a weakening dollar come at the same time of record oil prices.

But the facts suggest we may be at the bottom of the dollar decline, and speculative runs on commodity prices may be nearing their end as well. A strengthening dollar and falling commodity prices would help reduce the severity of the recession.

If commodities are valued in relation to the dollar's devaluation, they have well overrun their defendable positions. If we believe that since 2001 the U.S. dollar has suffered from hidden inflation, as much as 5 percentage points above official inflation, the effect should have devalued the dollar by 40 percent.

But commodity prices are showing incredible gains — well beyond a 40 percent devaluation of the dollar.

Oil is up 450 percent since the end of 2001. Natural gas up 156 percent. Copper up 300 percent.

During the past five years, industrial metals rose by 400 percent. Wheat and soybeans are up more than 70 percent in the past 12 months alone.

With the dot-com and housing bubbles having burst, a new wave of "analysts" are saying the demands for commodities will never slacken.

Don't believe them. The current commodity bubble is about to pop. This pop may not lead to the collapse of commodity prices like we have seen with other bubbles, but it will lead to a return to a price relevant to the dollar's real value.

Several factors will lead to a commodity re-appraisal.

First the dollar is stabilizing. It may be hitting lows, but it's bottoming.

The major dollar decline began in 2001, when former Fed chief Alan Greenspan injected tremendous liquidity into the U.S. economy, dropping rates to 1 percent.

At the same time, other central banks did not follow our lead and kept rates higher — as much as 400 basis points higher. This caused huge downward pressure on the dollar as global investors fled our inflationary currency for others that were less inflationary.

Today, that situation has changed.

Even with recent Fed rate cuts, the differential between the benchmark federal funds rate and the ECB rate is now just 100 basis points. And the good news out of the recent G7 meeting was that the major powers agreed they would need to work in tandem with U.S. Fed rates.

Indeed, the weak dollar was only helping U.S. exports at the detriment of Europe and Japan. (One recent headline noted that the U.S. saw a record number of foreign visitors — another support for the view that a weak dollar has some beneficial side effects.)

Tuesday's Fed coordination with other central banks to support mortgage lending and increase swap lines is another indication that the process to help the dollar is under way.

In addition to a stronger dollar, another factor leading to this commodity price bust is the recession itself.

The U.S. represents roughly a quarter of global GDP. A slowdown here will dramatically affect China, India and other emerging economies. Demand for commodities will slacken. It may take a little time, but it will happen.

This slackening won't cause a commodity price collapse, but it will re-adjust prices down, which will help to soften the recession.

We saw how a slackening of demand created a significant fall off in housing prices. Prices and even rents are re-adjusting down, which is deflationary, though it won't spark deflation across the board.

In some markets, buyers already are paying about 50 percent off of list prices for homes — just what Sir John Templeton predicted.

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One bubble after another seems to be striking America.The first great bubble, perhaps the largest in human history up to that time, was the dot-com bubble.It popped in 2000.The dot-com bubble was followed by the housing bubble. In 2005, The Economist magazine called that...
Wednesday, 12 March 2008 02:58 PM
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