Tag Archives: Commodities

Seeing the Positives from the European Debacle

What happened in the stock market two weeks ago was scary: the Dow dropped 1,000 points in a matter of minutes.  Greece was on the brink of defaulting on it’s debt; a country I might add, that has it’s currency denominated in Euros.   Investors were worried that if Greece went down, it might drag down the Euro with it.  Luckily, the EU finally pushed politics aside and realized that in order to keep the EU from causing a European Lehman chain reaction, they had to bail out Greece.  If Greece went, so the saying goes, the rest of Portugal, Italy and Spain would go with it.  As the bail out was announced, U.S. stocks surged.  But the damage was done.

Stocks are still up since a year ago, but a lot of that equity was lost.  Some say it was a much needed market correction.  In a way, I agree.  Investors started to feel that they were being left out of the party (considering that stocks rallied considerably since March 2009) and wanted to get into the action, driving up valuations.    The market correction has left some worried that the lost momentum from the stock market and the teetering European situation means that the U.S. is going to lose steam in it’s recovery.  But it won’t; it will only make our recovery stronger.  There are several positive indications that Europe’s struggle is in America’s benefit.

  1. A stronger dollar against the Euro should help bring in an influx of investment.  While a weaker dollar sent investors over seas, most wealth generated outside of the U.S. will start seeking to invest here.*
  2. The Fed funds rate is still around 0% to .25%.  Inflation hawks are going to have to start rethinking their position as deflationary pressures continue to rear its ugly head.  Mean trimmed CPI is on a downward trend, and with energy and commodity prices pointing lower, it will only continue to send overall prices downward.   This type of environment will keep the Fed from raising rates, making borrowing cheap.  With mortgage rates continuing to be low, buying a house is still attractive.
  3. The potential benefit for having low interest rates is that foreign investors looking for returns will look towards equity markets.  This means more potential growth for U.S. companies and the stock market.
  4. The stock market wasn’t the only thing that experienced slides.  So did commodity prices, especially oil.  Oil was moving up to around $90 a barrel until the market correction happened.  Now, oil prices are down to $75 a barrel.   Any increase in gas prices is taxing on consumers, but so far, gas prices have stagnated and won’t be increasing any longer.  The cost of inputs are now lower across the board thanks to declines in commodity prices, providing cushy margins for companies that lowers the pressure to raise prices, resulting in an absence of pain for the consumer.

As you can see, there is upside to the European situation.  I agree that it is still a gloomy situation for Europe in general.  Greece (and the like) face long-term structural issues that will make resolving their situation an incredibly hard task and I won’t be surprised if in 6 months Greece begins to default on its debt again.  But will it really drag down the EU? The rest of the countries such as Portugal, Spain and Italy should benefit from a lower Euro, helping wages that outpace productivity come to parity.  So should Germany and the rest of Europe, as a lower Euro will stimulate exports.  What needed to happen was a devaluation of the Euro  to a value more inline of what it is worth.  Yes, it is unfortunate that these irresponsible countries are essentially a drag on the EU, but that doesn’t mean the U.S. will have to suffer for it.

While the EU is a major trading partner to the U.S., I doubt there will be significant drops in demand for U.S. goods. There are more, higher growth areas for the U.S. to consider.  In terms of the U.S. recovery, if exports were the upside to the U.S. downturn, then U.S. exports to Europe is going to be the downside to the U.S. recovery.  But there is going to be a recovery nonetheless.

*And in minutes, this pops into my RSS reader: China boosts holdings of US Treasury debt by 2 pct

Do commodity futures accurately predict commodity prices?

From Econbrowser’s Menzie Chinn:

This paper examines the relationship between spot and futures prices for a broad range of commodities, including energy, precious and base metals, and agricultural commodities. In particular, we examine whether futures prices are (1) an unbiased and/or (2) accurate predictor of subsequent spot prices. While energy futures prices are generally unbiased predictors of future spot prices, there is much stronger evidence against the null for other commodity markets. This difference appears to be driven in part by the depth of each market. We find that over the last five years, it is much harder to reject the null of futures prices being unbiased predictors of future spot prices than in earlier periods for almost all commodities. In addition, futures prices do approximately as well as a random walk in forecasting future spot prices, and vastly outperform a reduced form empirical model.

Hit the link if you want to see the specifics. To paraphrase, this doesn’t mean that futures prices are guaranteed to predict actual commodity prices, but on average they are right. For financial analysts, that may be all that they need to hear. If on average, I could hedge my bet that the commodity price will reflect the futures prices, why wouldn’t traders use the forward momentum to drive prices upward? More so, when a major buyer like an oil refiner (in the case of oil) was squeezed and makes a major sell off in order to keep from paying a higher price on oil, would the momentum generated in the other direction drive prices drastically lower until a major player decided to cover their bets and drive the price up again?

This graph (from the paper) shows the average t-stats against the trade volume:

What I take from this is that the greater the variability, the less accurate futures are in predicting prices. Seeing that oil is at the highest trading volume but the least t-stat lets me assume that the oil market isn’t where a strategy could take advantage of the statistical phenomena. What could happen though is that as trading volume increases as traders try to capture the predicted commodity prices from future prices, (a la driving up the futures price) you end up with greater variability in price over all.

That’s doesn’t sound too good for price stability. If it is actively known that such a statistical relationship exists, and trader’s can’t exploit it, then one would conclude that commodity prices are accurately priced. However, if such a statistical relationship exists, trader’s knowingly exploit it, and variability in pricing occurs greater than its historical variation, then one can conclude that commodity prices are derived from speculation.

Commodity Price Inflation

Econbrowser has an interesting analysis on the recent, average commodity appreciation of 34%. This graph, which is from a recent paper by Ke Tang and Wei Xiong, has certainly resonated with me:

Why the correlation between certain commodity prices and oil? It is important to note that the correlation uses a rolling sample beginning one year before indicated date of returns on oil versus commodities. Unlike popular belief that currency devaluation is driving the recent commodity boom, rising oil prices is the major driver for commodity inflation.

The paper also believes that commodity inflation have been caused by commodities becoming a popular investment vehicle. However, I believe that is simply a consequence of rising world demand. If the former is true, then we would have another bubble in store. If the latter is believed, then we would expect worldwide inflation. Depending which comes first, both may be in the same feedback loop, so unfortunately, both would create a vicious cycle where as one increases, the other follows.

One would think that an increase in rates would immediately fix this.  But, that may be premature.  If oil is the big driver, then what is really needed is substitution away from oil.  Could lithium become the next commodity to drive commodity price inflation after a huge electric car boom takes charge during another oil shock? What other alternatives are there? Tax fuel for all non-commercial vehicles (electric or not)?