Commodities and the Great Conundrum
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 email@example.com)