Commodities and the Great Conundrum

November 3, 2008

John Kemp– John Kemp is a Reuters columnist.  The views expressed are his own –


By John Kemp

LONDON (Reuters) – By driving up long-term real interest rates, the forthcoming flood of U.S Treasury borrowing threatens to crowd out the amount of capital for investing in other asset classes, creating a much tougher environment for commodity prices over the next two to three years.

Like many other asset classes, commodity prices have benefited from an influx of funds in recent years driven by three related factors:

(1)  The long-term downtrend in inflation, greater macroeconomic stability, and heightened confidence in fiscal and monetary policy since the early 1980s have resulted in a steady reduction in both nominal and inflation-adjusted interest rates. Real rates are down from +8.0 percent in 1984 and +4.5 percent at the start of 1995 to -0.5 percent in H1 2008, or +1.5 percent if rising food and energy costs are excluded (see chart https://customers.reuters.com/d/graphics/US_RLINT1108.gif).

As real returns on benchmark government bonds have shrunk, investors have shifted into higher risk asset classes (equities, hedge funds, private equity and commodities) in search of better returns.

(2)  Current account surpluses from China’s export-related boom and OPEC’s torrent of petrodollar revenues have been smoothly recycled back into debt markets, private equity, hedge funds and other instruments in North America and Western Europe.

China’s surplus savings and proceeds from foreign exchange intervention, coupled with the windfall revenues from higher oil and commodity prices in the Middle East, have been neatly matched by the willingness of households and firms in the United States, Europe and the Anglo-Saxon economies to borrow and spend.

The result was an unusually long period of synchronized but mostly non-inflationary growth in the major economies of North America, Western Europe, Japan and the rest of Asia between 2003 and 2007, with strong inflationary pressures only becoming explicit toward the end of the period.

(3)  Smaller cyclical variations and the financial system’s ability to bounce back quickly after the Asian financial crisis (1997), LTCM (1998), the collapse of the dotcom boom (2000-01), Enron (2001) and the attacks on the World Trade Centre and Pentagon (2001) seem to have made investors more confident and increased appetite for taking on more apparent risk in search of higher returns.

Tolerance for short-term volatility has increased as investors have focused on projected long-term capital growth. The existence of a “Greenspan put” on equity and other higher-risk asset prices has seemed to limit extreme downside risks. Coupled with the apparent protection from portfolio diversification, it has resulted in both retail and private investors shifting their portfolios to contain a much greater proportion of higher-risk assets.

The result of these three factors was an unusually long period of sustained growth, with low inflation and low long-term interest rates lasting almost five years from 2003-2008.

Former Fed Chairman Alan Greenspan described the failure of long-term rates to rise significantly even as the Fed began to normalize short-term rates from June 2004 onwards as a “conundrum”. While long rates did start to rise from late 2005 onwards, the rise was nowhere near what would have been anticipated given the sharp escalation in inflation, much of it driven by rising commodity prices. Real interest rates slid to the lowest levels in more than twenty years.

Falling real rates diverted a huge flow of investment funds away from the core financial markets (government bonds and equities in North America and Western Europe) towards higher-risk but higher-yielding instruments (emerging market equities, commodities, real estate, structured mortgage products) and encouraged the use of more leverage to boost returns further.  The result was a broad inflation of a wide range of asset prices from real estate to emerging market stock indices and fine art.

Commodities were slower to benefit than some other assets. But once the excess capacity inherited from the 1990s had been absorbed, commodity prices began to rise explosively from 2004 onwards.

The conundrum has supported commodity prices in two ways: (a) providing an unusually long period of sustained growth and giving central banks comfort to tolerate rapid expansion despite the emergence of obvious capacity pressures; and (b) stimulating the large-scale flow of funds from lower-risk bond markets towards commodity indices and actively managed commodity hedge funds in search of higher returns. The first might be termed the “real” transmission channel, the second the “financial” one.

But in the wake of the financial crisis, the conundrum threatens to go into reverse, creating a much more hostile environment:

(1)  The U.S Treasury’s forthcoming flood of debt issues threatens to drive up long-term interest rates. The volume of funds the Treasury needs to borrow within twelve months has doubled from $1.5 trillion in Oct 2006 to more than $3.0 trillion in Oct 2008. For the time being, the Treasury can take advantage of strong safe haven flows to issue short-term securities at yields below 1 percent. But the appetite for longer-dated paper is untested.

Officials have spoken about reintroducing three-year notes – suggesting investors are comfortable with inflation and devaluation risks over the next 12-18 months but more uncertain about the outlook beyond that timeframe. Nominal rates on benchmark ten-year paper have not fallen significantly since the onset of the crisis, even as inflation has abated, suggesting the market is now demanding much higher real rates.

(2)  Sharp falls in commodity prices and slowing export growth will cut the volume of petrodollars and foreign exchange accumulation that needs to be recycled into U.S and European asset markets.

(3)  Increased volatility is curbing appetite for risk, especially among sovereign, institutional and retail investors, or at least fuelling demands for better compensation in terms of higher dividends, coupons and steep discounts on new issues. Appetite for mortgage-backed securities has largely evaporated, while credit spreads on even mid-grade corporate debt have surged.

This new environment will have a negative impact on commodity markets through both real and financial mechanisms.

The Treasury’s massive borrowing programme, coupled with lower appetite for risk and wider spreads, will substantially raise real debt costs and intensify the slowdown in corporate investment, construction activity and household consumption over the next two years.

The downturn which began in the U.S construction sector in mid-2006 is now spreading to other sectors (commercial construction, manufacturing and services) and internationally (to Europe, Japan, China and Australasia). Consumption of crude oil products has been falling in the United States for almost a year and the downturn is now spreading to steel, aluminium, nickel and other construction materials.

On the financial side, higher real rates and a reduced appetite for risk looks set to pull investment funds back from the periphery of the financial system (emerging markets, commodities, junk paper) and back towards the core (government bonds and blue chip equities in North America, Western Europe and Japan). The general reduction in investable funds as recycling flows diminish will amplify the trend.

As Greenspan’s conundrum reverses, the virtuous circle of strong growth, low interest rates and strongly rising asset markets threatens to unwind. Commodity prices will still draw support from rising long term demand, higher costs, and greater industry consolidation.  But the market faces strong headwinds over the next 2-3 years as rising debt issues and real interest rates crowd out other investment and consumption spending, and reduce the attractiveness of assets on the periphery of the financial markets.

(You can reach John Kemp at john.kemp@thomsonreuters.com)

31 comments

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Ha, ha!! It is interesting that someone at Reuters chose this as the best comment.”Replace tax with inflation? that’ll mean that the billionaires are effectively being taxed the same rate as the minimum wagers ” What a joke. Billionaires for the most part (if they are using the tax loopholes already at their command, are paying a lesser rate than the workers. It is this kind double-talk that has gotten us into this mess in the first place. The only way to get everybody to pay taxes is to tax the currency. Every other form of taxation gets “mission creep”. That where the creeps pay their lobbyists to make tax laws that benefit them.

In every society there is a healthful balance between the urges to take care of one’s self and those to take care of one’s community. Both are natural impulses. But when they get as out of balance as they have during the Bush (to the very wealthy: “I am your guy”) years, it is such a radical move in the direction of selfish behavior that most people have come to think that they were fools if they didn’t play the game.

If this “me-we” balance is not redressed, we are in for some very hard times.

Posted by Jonathan Cole | Report as abusive

There are the tools of measurement of the time with second, weight by gram and so on.
Then why we do not use the “joule” for measuring the value. The median of all exchange in the world. Anyone can calculate the total energy to be spent to produce any given goods or services. If we can measure and calculate the total energy to be spent any given goods and services then we can use the “Joule” as median of exchange. No cheating the third world any more . think of that!!

Posted by ihsan | Report as abusive

Maybe you’re right J Cole, but mission creep would also stop your proposed ‘currency tax’. I still believe that there is no way that a uniform tax rate for all levels of income and for all corporations would ever work. You’d see a massive exodus of companies away from the toxic US dollar, no one would loan the government any money, and pretty soon the currency wont be worth the paper its printed on.

Hyperinflation obviously isnt working for Zimbabwe is it? The country issued a 1 million dollar note this week (after chopping off 10 zeros from the denominations in August)

Posted by Andrew | Report as abusive

The yield curve is steepening as long-term inflation expectations are increasing. The U.S. budget deficit is not going to be addressed by the government increasing the tax burden placed on its debt-strapped, increasingly unemployed, citizenry. The \’solution\’ will be to devalue the U.S. dollar. Hard assets at home will retain their real value while foreign-held U.S. dollar-denominated debt will pay the price. The trick will be to accomplish this massive wealth repatriation without incensing the world.

Poot roles down hill.
I own a couple of companies
One makes money (1 employee)the other does not (27 employees)
As my taxes go up I have less money to try and carry the really good people that work for me – 20 years. If things get worse – I will have to shut down a salvage the building & equipment.
If Washington was not sucking all the air (money)out of the economy we might have a chance.

but we – and I think we all know it are SOL
These desperate tmes breed socialism junkies and that spells the end to Americas greatness.
Good luck to us all

Posted by AR3 | Report as abusive

So, the Govt. needs to BORROW 3 Trillion bucks because it wants to spend 3 Trillion bucks more than it has. GO TO BLAZES!! Take it out of their Washington paychecks NOT OUT OF My POCKET. john

It seems to me there is some illogic in Mr. Kemp’s assertions.

As I interpret his comments, he is saying that the need for large new issues of government debt will drive long-term interest rates up, because the debt won’t be possible to sell unless it offers attractive interest rates.

Then he is saying that because of government debt will be an attractive investment instrument on account of its high yield, investors will prefer to put their money into government debt instead of alternatives such as commodities.

Does this strike anyone besides me as a circular argument?

Posted by lance sjogren | Report as abusive

Wisdom at any level may not be viewed by all the same way..volitilitywill be the true theme going forward..Trading the charts will be the only way to have a chance..discount broker stocks are a safe play

Another point:

Kemp argues that a “reduced appetite for risk” will steer investors toward government bonds.

Certainly at this moment, US government bonds are viewed as the “safe haven”. Although part of the reason for the popularity of US dollar instruments may simply be as many have commented that the currency in which all the mortgage derivatives garbage has to be unwound is the US dollar, hence all those parties involved in the sordid derivatives business must build up as big a pile of dollars as possible.

But why would Kemp believe that US government bonds will be attractive to those with a “reduced appetite for risk” in the future? Indeed, the only reason for the higher interest rates he predicts for them in the future is precisely that they will NOT be viewed as low-risk, and therefore must offer a high yield to compensate for a substantial risk.

The risk of course being that devaluation of the dollar will result in them providing a negative real return, something which they in fact already do.

So why in the future would people with a “reduced appetite for risk” decide that US government bonds were a better choice than commodities?

Simply because that happens to be the case today?

Some of Mr. Kemp’s points seem to me to make sense, while others do not make any sense to me whatsoever.

Posted by lance sjogren | Report as abusive

A couple additional weaknesses in Kemp’s comments:

1). Although he acknowledges fundamentals have some role in commodity prices, he seems to feel that investors have far more influence on commodity prices than fundamentals do. Again, in the last few months that clearly has been the case. Perhaps he is right that they will continue to for the next 2-3 years. If it takes that long for the deleveraging of financial garbage to take place, perhaps he may prove to be correct, although I personally think that the short-circuiting of the commodities market by the investment community is already waning, and fundamentals are beginning to once again reassert themselves.

2). Looking at the fundamentals, commodities cannot be treated as a monolithic market. Gold is a monetary commodity, far different than copper, which is an infrastructure-related commodity. Oil is considerably different than most other commodities, in that it is probably the most economically essential commodity and its supply is on the verge of a rapid descent, greatly overriding any demand weakness (and demand is expected to still be rising, albeit slowly, during the current global economic slowdown).

I guess if you believe as Kemp appears to that financial markets will dictate commodities prices for some time to come, then one would consider the fundamentals to be irrelevant.

I do not share that view.

Posted by lance sjogren | Report as abusive

procera said:

“The trick will be to accomplish this massive wealth repatriation without incensing the world.”

I think the US’s foreign creditors comprehend fully that the US is bankrupt and can never pay back the money it has borrowed. They will simply write off the devalued dollars.

The system up to now has benefitted nations such as China. China can now stand on its own two feet. If they have to burn their worthless US dollars, I think they have seen that coming all along and will simply consider it the price they had to pay to jump start their economy to the point where the US is no longer of any benefit to them.

Posted by lance sjogren | Report as abusive