Are we in the ninth inning of the “Commodity
Super Cycle” that has lifted the Reuters Jefferies Commodity (CRB) price index
91% higher from four years ago to its highest level in 26 years? The Reuters
Jefferies CRB index of 19 commodities reached a high of 349.56 on Jan 30th and
is comprised of futures in live cattle, cotton, soybeans, sugar, frozen
concentrated orange juice, wheat, cocoa, corn, gold, aluminum, nickel, unleaded
gasoline, crude oil, natural gas, heating oil, coffee, silver, copper and lean
Barclays Capital said on January 5th that commodity investments
might parlay another $40 billion this year up to $110 billion as pension funds
and other money managers diversify from stocks and bonds. Big-money investment
funds have boosted their stake in commodity indexed markets to around $70
billion in 2005, up from $45 billion by the end of 2004 and only around $15
billion at the end of 2003.
Pension funds, as well as small, retail investors are looking to commodities as
a crucial part of diversification of any investment portfolio. Although
schizophrenic commodity day traders could decide to turn massive paper profits
into hard cash at a moment’s notice, causing a 5% shakeout, the longer-term odds
still favor a continuation of the “Commodity Super Cycle, into extra innings.
Central bankers point the finger of blame for soaring commodity
prices on China’s juggernaut economy, which has expanded at breakneck speed of
10% for each of the past three years, competing with rampant demand for basic
resources from big importers like India, Japan, Germany, South Korea, and the
United States. India’s booming economy expanded 8% and Korea’s by 5% last year.
China bought about 22% of the global output of base metals in 2005, compared
with 5% in the 1980’s, and has doubled its crude oil imports from five years
Central bankers stare at the explosive CRB rally from the
sidelines with a sense of indifference or stone faced silence, though sharply
higher commodity prices are telegraphing higher producer price inflation.
Furthermore, China is under daily pressure from the Bush administration to
revalue its yuan higher against the dollar, which in turn, would give Beijing
even greater purchasing power abroad, and provide more support for a whole range
of commodities from crude oil, iron ore, zinc, copper, platinum, uranium,
soybeans, and ethanol.
But perhaps, the simplest answer to explain the long term
bullish outlook for global commodities boils down to one simple equation.
According to the latest population count by the United Nations, the world had
6.5 billion inhabitants in 2005, 380 million more than in 2000, or a gain of 76
million persons annually. By 2050, the world is expected to house 9.1 billion
persons, assuming declining fertility rates. In other words, a world of finite
raw materials, along with an increasing population base, translates into higher
Until recently, the “Commodity Super Cycle” has been led by base
metals such as copper, aluminum, and zinc, precious metals such as gold, silver,
and platinum, and higher energy prices led by crude oil and natural gas.
Recently however, commodity traders have doubled sugar prices to 24-year highs,
and are moving into coffee and soybeans. Other raw materials such as iron ore
rose 72% in 2005. Although China is a big exporter of steel, fears of a global
supply glut could disappear rapidly, if global steel makers begin a pattern of
consolidation, following in the footsteps of the gold mining industry over the
past few years.
But how did the Reuter’s CRB index reach record levels in the
first place? Well consider the Chinese and Indian economies, which also account
for one third of the world’s population, and the super easy money policies
pursued by the big-3 central banks, the Bank of Japan, the European Central
Bank, and the Federal Reserve. Both ingredients, when mixed together, make an
explosive cocktail that has lifted commodity indexes into the stratosphere.
And a trend in motion, will stay in motion, until some major
outside force, knocks it off its course. So not withstanding inevitable
profit-taking sessions, what major outside force is out there that could derail
the CRB’s upward trajectory?
Chinese demand for imports has soared by 330% from roughly $15.5
billion per month in early 2002 to a record $64.4 billion in December 2005.
China is the world’s fifth largest importer, and bought $632 billion worth of
goods in 2005. The world’s number-one miner BHP Billiton BHP.AX ran its mines
and smelters at full speed in the fourth quarter to capture strong commodities
prices, setting the stage for full-year profits to exceed $9 billion. Rio Tinto,
RIO.AX, the world’s second largest miner pushed its operations harder to double
its 2005 profit to around $5 billion.
China's economy overtook France and the Great Britain to become
the world's fourth largest last year, and will grow an estimated 9.4% this year.
The European Union and Japan expect growth of 1.9% this year. Chinese Premier
Wen said on December 1st that China needs to “maintain rapid and stable economic
growth to raise the living standards” of the nation's 1.3 billion people, whose
per capita income of $950 per year, ranks 129th in the world. Beijing is cutting
taxes and raising salaries to encourage more spending on cars and household
Exports are a key driver behind the Chinese economic miracle,
with China's currency exchange controls and trade surplus with the US topping
$204 billion in 2005, a 25% increase on the previous year and nearly 30% of the
total US deficit. The lynchpin of Chinese exports is the low yuan /dollar
exchange rate pegged at 8.11 per dollar, undervalued by 30% to 40% on a trade
The People’s Bank of China increased its M2 money supply by
18.3% last year, issuing more yuan to soak up foreign currency earned through
foreign trade and direct investment into Chinese factories from abroad.
Explosive money supply growth, in turn, boosted domestic retail sales by 13%
last year, and industrial production was 16.6% higher in November from a year
earlier. China’s central bank raised its M2 money supply target to 17% in the
third quarter from 15% earlier, to offset stronger demand for the yuan, and
maintain the peg at 8.11 per US dollar.
China’s crude oil imports rose 4.4% in the first 11 months of
2005, and are expected to total 130 million tons of crude (2.5 million bpd) in
2005. Crude oil production from China's biggest oil field, Daqing, fell about 3%
to 44.95 million tons (900,000 bpd) last year. China, the world's second-largest
oil consumer, expects to secure foreign energy supplies with foreign deals for
its economy, after it turned into a major oil importer and still suffers from
severe power shortages.
China's oil giant Sinopec signed a $70 billion oil and natural
gas agreement with Iran, to buy 250 million tons of liquefied natural gas over
30 years from Tehran and develop the giant Yadavaran field. Iran is also
committed to export 150,000 barrels per day of crude oil to China for 25 years
at market prices after commissioning of the field. Iran is China's biggest oil
supplier, accounting for 14% of Chinese oil imports. In return, Tehran’s
Ayatollah is demanding a Chinese veto at the UN, to shield his secret nuclear
weapons program from international sanctions.
India’s Prime Minister Manmohan Singh, wants his country to
achieve 10% economic growth in the next two to three years, to create more jobs
and help lift a third of the country's 1.1 billion people out of poverty. Asia's
fourth-biggest economy expanded 8% in the second and third quarters of 2005.
Singh's government wants industrial production, which makes up a quarter of
India's economy, to grow 10% annually to boost the incomes of Indians, one in
three of whom live on less than $1 a day.
India’s industrial production grew at an annualized 8.3% rate
between April and November 2005, faster than major economies like US, UK, the
Euro zone, Japan, Brazil, Indonesia and Russia. Only China and Argentina
recorded faster industrial production rates of 16.6%, and 9.6% respectively. On
the global sphere, US industrial production grew only 2.8%, and the UK, the Euro
zone, and Indonesia, saw declines of 2.4%, 0.8%, and 3.4% respectively in their
overall industrial production.
Indian economists have observed an 86% correlation between
industrial production and exports. But the Indian export sector does not
dominate growth in the Indian economy, such as in China and South Korea. The
Indian economy is more about domestic consumer demand, which contributes nearly
70% to GDP, while exports contribute only 15% to India’s GDP. India ranked 24th
among global importers purchasing $113 billion of goods in 2005, or about a
sixth Chinese demand.
Japan is also a major factor behind the rise in global commodity
prices, with industrial production rising for a fifth month in December to a
record, sustaining the nation's longest expansion in eight years. Japanese
industrialists plan to spend 17.3% more on factories and production facilities
in 2006 than last year. Overseas sales are also bolstering production and
imports of raw materials from abroad. Japan imported $451 billion of goods in
2005, the seventh highest among global importers.
Japan's exports rose 14.7% in November from a year earlier to
5.9 trillion yen ($50.2 billion), the second highest ever, on the heels of the
yen’s 19% devaluation against the dollar, and 17% drop against the Chinese yuan.
Shipments to China rose 12.8% and those to the US climbed 8.9 percent. Exports
were up for the 23rd consecutive month while imports rose for the 20th month in
To meet strong demand from abroad, and an economic revival at
home, Japanese imports of raw materials have soared 66% to 5.42 trillion yen per
month from three years ago, and in turn, providing underlying support for global
commodity prices. Japan paid 20% or more for nonferrous metals, crude oil and
coal in 2005, which companies are expected to pass on to customers.
Japan’s wholesale price index was 1.9% higher in November from a
year earlier, and has been in positive territory for two years, but the Japanese
government claims that consumer prices are just emerging from a seven year bout
of deflation. But the Japanese wholesale price index tracks major trends in the
Reuters Commodity price index, which has risen 91% over the past four years, for
an annualized gain of 23%, much higher than the Japanese wholesale price index
of 1.9% inflation.
That would imply that Japanese manufacturers are getting
squeezed by sharply higher raw material costs, and unable to pass costs along to
intermediaries. Yet, large Japanese manufacturers claim their profits are
expected to be 5.2% higher in 2005, and the Nikkei-225 stock index rose 40% last
year to a 5-year high. If correct, then profit margins might have been inflated
by a stronger dollar against the Japanese yen. That explains why the Japanese
ministry of finance is jawboning or intervening in the currency markets,
whenever the dollar has a rough day.
Global commodity prices bottomed out in late 2001, soon after
the Bank of Japan lowered its overnight loan rate to zero percent, and adopted
quantitative easing. The central bank prints about 1.2 trillion yen ($10
billion) per month to purchase Japanese government bonds, inflating the amount
of yen circulating around global money markets. More Japanese yen yielding zero
percent, chasing fewer natural resources in turn, leads to sharply higher global
The Japanese ruling elite are devaluing their way to prosperity,
by flooding the Tokyo money markets with 32 trillion to 35 trillion yen above
the liquidity requirements of local banks. The enormous supply of excess yen
pushed Japan’s 3-month deposit rate below zero percent for most of 2004. With
borrowing costs at zero percent or less, Japanese and foreign hedge fund traders
have found the cheapest source of capital to leverage speculative positions in
And the Japanese ministry of Finance is not expected to grant
permission to the Bank of Japan to begin mopping up some of the excess yen until
the second half of 2006, at the very earliest. On January 9th, Japanese Finance
Minister Sadakazu Tanigaki said, "There is a need for the BOJ to make a careful
assessment of data. It should not rush things.” The BOJ is certainly not rushing
things. It has kept the overnight loan rate pegged at zero percent for five long
Kozo Yamamoto, the ruling LDP party chairman on monetary policy
matters expressed outrage at the prospects of a BOJ policy change, saying
quantitative easing must stay in place to eradicate deflation for good and to
keep bond yields low to help the government trim debt servicing costs. "But if
the BOJ were to ignore our view and force through the same mistake it made when
it ended the zero rate policy in August 2000, ending up with a miserable
outcome, we would then revise the BOJ law of independence,” he warned.
The European Central Bank cannot ignore the Euro zone's loose
monetary conditions and increased risks to price stability, said ECB chief
economist Otmar Issing on December 19th. "Money growth has been high for quite
some time and credit growth has continuously increased, supporting our
assessment of the risks to price stability. Liquidity in the Euro area is more
than ample. A central bank with the mandate to maintain price stability cannot
ignore these signals," Issing added.
Yet for two and a half years, the ECB ignored a 50% surge in
commodity prices, since lowering its repo rate to 2.00% in May 2003. The Euro M3
money supply growth rate was 7.6% higher in November from a year earlier, above
the central bank’s original mandate of 4.5% growth. Thus, the ECB’s
quarter-point rate hike to 2.25% in December was too little, too late, to get in
the way of the “Commodity Super Cycle,” with the Reuters CRB rising another 10%
in its aftermath.
Italian central banker Bini Smaghi spoke with a twisted tongue
on the matter on January 25th. "If a central bank stops excess liquidity too
late it has to raise rates much more strongly and that causes turbulence on the
markets.” Then, casting doubt about the ECB’s resolve to combat commodity
inflation, Smaghi said there are a range of risks to durable economic recovery
in the Euro zone. “There are no clear signals about how strong growth really is.
That's why we've got to be careful in this early stage of the recovery," Bini
For the past three years, the ECB pursued a policy of “asset
targeting”, inflating its Euro M3 money supply to lift European stock markets
into higher ground, and through the “wealth effect” lift the spirits of the
frightened European consumer. The ECB is running into a barrage of resistance
from top European finance officials to higher Euro interest rates, fearful of
any action that could undermine the European stock markets. The ECB has much
greater political independence than the BOJ.
Sending a clearer signal on January 23rd, ECB economist Issing
argued, "Trichet made it very clear. The December rate hike was not the first in
a series of steps. But we will always act on time. The risk to price stability
has increased in the context of higher oil prices," Issing said, adding that
Euro zone consumer inflation, which fell to 2.2% in December, was likely to rise
The ECB’s Klaus Liebscher also expressed concern that the
sustained high cost of oil would feed into wages and prices for other goods and
services. "Without a doubt, there is still a large danger," he said, citing the
German producer price index, which rose by 5.2% in December, its fastest pace
for 23 years. Traders should always trust the hard dollars and cents flowing
through the commodity markets for real time indications of future inflation, and
not government statistics.
One has to question how the Japanese wholesale price index is
only 1.9% higher from a year ago, or roughly 3.3% less than the German PPI, when
the yen was 6% weaker than the Euro against the dollar last year. But in an age
where ruling parties distort data to serve their own interests, it is hardly
surprising that Japan’s financial warlords present price indices and inflation
data in a manner best suited to their immediate needs. There is simply is no
limit to how far the Japanese government will go to keep its borrowing costs
down and to protect the interest of its exporters.
Because most commodities are traded in US dollars, the Federal
Reserve has a special role to play in the fight against commodity inflation. The
Fed must protect the value of the US dollar in the foreign exchange market, with
higher interest rates if necessary, to keep the Commodity Super Cycle in check.
Yet the Greenspan Fed waited for the Reuters Commodity price index to rise by
45% above its 2001 low, before taking its first baby step to lift the fed funds
rate by a quarter-point to 1.25%.
The Fed has moved in predictable quarter-point moves for the
past eighteen months, and has signaled that 4.50% could be the peak in the
tightening campaign. The Fed is targeting US home prices, which have flattened
out in recent months, and should preclude further rate hikes in 2006. Still, the
Fed’s go-slow approach to combating inflation has left it far behind the
“Commodity Super Cycle.”
The Greenspan Fed produced a sizeable counter trend rally for
the US dollar in 2005, pushing the greenback from 102-yen to as high as
121.50-yen, and knocking the Euro from as high as $1.3450 to a low of $1.1650.
However, the Fed efforts to control commodity inflation were completely
undermined by the super easy money policies of the Bank of Japan and the
European Central Bank.
How would the new Fed chief Ben Bernanke react, if commodity
prices were to continue to soar further into the stratosphere? Without the life
support of higher interest rate expectations, the deficit ridden US dollar could
come under renewed speculative attack in 2006. Especially, after China signaled
a desire to diversify an expected build-up of $200 billion of foreign currency
reserves away from the US dollar this year. A weaker dollar could give commodity
prices extra support.
Fortunately for commodity bulls, Bernanke doesn’t believe there
is a link between a higher CRB index and higher producer price inflation. On
February 5th, 2004, Bernanke said, “rising commodity prices a variable of growth
rather than inflation.” Then on May 24, 2005 Bernanke played down worries about
higher energy and commodity prices. “Much of the recent price gains in energy
and commodities reflect the rapid growth of the Chinese economy. Chinese
authorities are now trying to slow that growth, and should help check the growth
of commodity prices,” he said.
Bernanke has also rejected opinions that the recent rise in oil
prices is largely a symptom of super easy central bank monetary policies. “The
consensus that emerges from this literature is that the relationship between
commodity price movements and monetary policy is tenuous and unreliable at best.
Moreover, recent experience doesn't support the notion that monetary policy had
a substantial effect on the oil price rise,” he said.
Then on October 25, 2005, the day after his nomination to lead
the Federal Reserve, Bernanke was asked again about soaring commodity prices and
their impact on the inflation outlook. "The evidence seems to be that it is
primarily in energy and some raw materials and has not fed into broader
inflation measures or expectations. My anticipation is that's the way it's going
Most likely, Bernanke would continue to ignore a surge in
commodity prices, but keep a close eye on US home prices. Any sign of a
significant downturn in US home prices, could quickly prompt the new Fed chief
to lower the fed funds rate. Already, home re-sales in the United States fell
5.7% in December to the lowest level since March 2004, after five years of gains
that shattered construction and sales records and sent prices up more than 55%
nationwide. The national median sales price in December was $211,000, and down
from a record high of $222,000.
The Greenspan Fed was an “Asset Targeter” and inflated US home
prices over the past few years to offset huge losses in the Nasdaq and S&P 500
stock indexes. The Fed borrowed this strategy from the Bank of England, which
pioneered home price targeting in 2001. By moving in baby step quarter-point
rate hikes, the Fed was careful to avoid a meaningful downturn in the housing
markets, until signs of froth in home prices were sprouting in over 100 major US
cities in late 2005.
Any sign of potential weakness in the DJ home construction index
towards the horizontal support at the 800-level, could be met by aggressive
half-point rating cutting by the Bernanke Fed to head off an implosion of
consumer wealth and confidence. A significant decline below the 800 level could
signal a head and shoulders top pattern to technicians, projecting a decline to
the 550-level. Fortunately, head and shoulder pattern rarely work anymore, and
usually just set bear traps. Sharp rate cuts by the Fed might bring Wall Street
investment bankers to the rescue of the housing sector.
So what could derail the “Commodity Super Cycle” in 2006?
Schizophrenic speculators could be tempted to lock in profits at a moment’s
notice. But big time players like China, Japan, and India could provide a safety
net for falling commodity markets, gratefully locking in lower prices for raw
materials. Beijing is on course to reach $1 trillion of foreign currency
reserves by years ahead. Base metal and precious metal dealers could be loathe
to offer big discounts to cash rich Beijing.
China is still holding a massive short position in copper
futures, estimated at below 200,000 tons because of positions amassed by trader
Liu Qibing. Yet there are only 140,000 tons of copper in publicly reported
stockpiles worldwide, equal to about three days of global usage, and stored in
warehouses monitored by the London Metals Exchange and commodity exchanges in
New York and Shanghai.
The Bank of Japan is aiming for negative interest rates by
forcing the “core” inflation rate to rise above its zero percent overnight loan
rate, before moving to tighten its monetary policy. Negative interest rates
would actually produce an easier money policy in Japan in the short term, and
possibly create a major bubble in the Nikkei-225 stock index. The ECB’s baby
step rate hike campaign would probably fizzle out near 2.75%, hardly enough to
scare anyone. And the Fed’s Bernanke is on guard against falling home prices.
Crude oil is hovering near record highs, fearful that Iran’s
Ayatollah might unleash the “Oil Weapon” in 2006, squeezing crude oil to $80 per
barrel, if Europe and the US muster the nerve to impose economic sanctions on
the Islamic regime. A battle in the Strait of Hormuz could disrupt oil supplies
and the supply of commodities worldwide. But high-flying Asian and European
stock markets are betting the Ayatollah will flinch at the eleventh hour to
avoid a military showdown with the US and NATO, and wipe out a $10 per barrel
“War Premium” for crude oil.
Weighing all the bearish and bullish arguments however, it’s
appears likely that the “Commodity Super Cycle” is bound to go deeper into extra
innings and reach new frontiers in un-chartered territory.
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