Quantitative easing and the commodity markets
-The views expressed are the author’s own-
A warning by an International Energy Agency (IEA) analyst this week that quantitative easing (QE) risked inflating nominal commodity prices and derailing the recovery drew a withering response from Nobel Economics Laureate Paul Krugman, who labelled the unfortunate analyst the “worst economist in the world”.
According to New York Times columnist Krugman “Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in terms if QE succeeds in raising real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery”.
Krugman’s criticism is unfair. There are clear links between QE and investor appetite for commodity derivatives and physical stocks (via the Federal Reserve’s “portfolio balance” effect), and from investors’ holdings of derivatives and physical inventories to cash prices (given the relatively inelastic supply and demand for raw materials in the short term).
In other words, there are financial as well as real economy links between QE and commodity prices. Commodities have some of the characteristics of financial assets as well as physical consumption materials. Via portfolio effects, QE could boost the relative (real) price of commodities even if it did not boost employment and output in the United States by very much.
It is a more open question whether commodity-driven inflation would hinder or promote a recovery in output and employment in the advanced industrial economies. It would reduce the real burden of inherited debts from the boom years. But it would harm savers, and it might harm manufacturers and households, depending on whether increased commodity prices were matched by rising non-commodity consumer prices and wages.
Overall, an unbalanced, commodity-driven inflation would probably be more of a drag on recovery than a help. Reasonable observers have reached different conclusions. In any event, the analyst’s warning was certainly not a “classic freshman mistake” or evidence of a new “Dark Age of economics” that the erudite professor labelled it.
Setting aside the transmission mechanism through real demand, QE is likely to boost investment allocated to commodities (derivatives and physical stocks of raw materials) by altering both prospective returns on different asset classes and the composition of instruments available for investors to include in their portfolios.
Financial transmission mechanisms between QE and commodity prices are complex. There are at least four channels by which large-scale bond purchases by the Fed and other central banks could flow through to higher commodity prices:
(1) RISK PREFERENCES
QE is designed to depress real inflation-adjusted returns on safe highly liquid instruments such as U.S. Treasury notes to force investors to increase their holdings of riskier assets such as corporate bonds, equities and ultimately physical investments like real estate, plant and equipment.
The Fed hopes that at least some private investors and institutions such as pension funds will choose to increase their risk exposure rather than accept lower returns on safe assets. It should prompt outflows from low risk low return assets such as government bonds towards higher risk classes including commodity derivatives.
(2) ASSET COMPOSITION
Large-scale buying of Treasury notes by the Federal Reserve System will reduce the availability of low-risk instruments for other investors. Private investors and institutions own just over $5 trillion of the marketable debt of the United States.
If the Fed purchases $500 billion worth of securities it would reduce the free float by 10 percent. With government borrowing running at more than $1 trillion per year, the actual impact on the float will be smaller. But large-scale purchases will still reduce the volume of low-risk debt available compared with its trajectory in the absence of the programme.
QE represents a form of reverse crowding out. In traditional crowding out theory, emissions of state debt crowd out private investment (shrinking the volume of funds available and driving up the cost of borrowing). By reducing the current and projected amount of Treasury securities in circulation, QE aims to crowd in private sector investment, which will include investment in commodity derivatives and physical stocks.
(3) OPPORTUNITY COSTS
By lowering interest rates and yields on government debt, corporate bonds and equities, QE will reduce the opportunity costs and financial expenses involved in holding long positions in commodity derivatives (embedded in the contango) and physical stocks (storage costs and financing fees).
Positions in physical raw materials or derivatives have been likened by the California State Teachers Retirement System (CalSTRS) and other institutions to a form of insurance. Most of the time commodity holdings lose small amounts of money as a result of storage and financing fees, but there are large positive payoffs during periodic price spikes associated with general inflation or commodity specific supply shocks.
By cutting the direct cost of financing positions, and reducing the positive yield on competing investments in equities and bonds, QE reduces both the absolute and relative cost of taking out this type of inflation insurance. At the margin it will make it more attractive for institutional investors to allocate funds to derivatives or physical stocks.
(4) PRICE EXPECTATIONS
If QE raises expectations about the average inflation rate in the medium term it may make more private investors and institutions keen to buy protect themselves against price rises by gaining long exposure to raw materials.
To the extent investors expect inflation to accelerate most in commodities (because of supply constraints, inelastic demand, and self-validating price feedback) it becomes even more important to hedge exposure as well as using commodities as a source of excess returns.
QE is not an exact science. The Fed itself is not certain about how much impact bond purchases would have on the yields of U.S. Treasury securities. One much cited paper suggests the first round lowered yields between 30 and 100 basis points, probably towards the lower end of that range. Officials seem even more uncertain how much impact a second round would have.
If the direct impact on bond yields is difficult to estimate, even retrospectively, the forecast effect on commodity prices, which is far more indirect, is impossible to quantify. Massive uncertainty surrounding other variables, the transmission mechanisms, and how QE will interact with investor preferences dominates any price forecast. It is essentially meaningless to say that $X billion of QE would add $Y to the price of a barrel of oil or a tonne of zinc. The uncertainty is simply too large for the prediction to be useful.
But it is possible to predict the effect on prices will be positive (since all the transmission mechanisms point in the same direction, from higher QE to increased investor demand for commodity derivatives and inventories).
It seems likely the biggest impact will be felt in markets where fundamentals are already strongest (given the non-linear nature of commodity pricing relationships and the heightened potential for bubbles to form as a result of positive feedback loops and self-validating price movements).
QE will favour most commodity investments in comparison with low-risk assets such as cash and bonds. But the differential impact across the sector suggests gains will be largest for relative-value strategies which overweight raw materials in shortest supply and underweight those with more comfortable supply-demand balances and inventories.
A rising tide of easy money will lift all commodities, but not equally. Differential impact from QE will provide perfect conditions to test the claims of a new generation of dynamic commodity indices (such as the SummerHaven/U.S. Commodity Funds Commodity Index) as well as fundamentals-based relative value active managers (such as VOC Capital Management and Curium Capital) that they can generate enhanced returns.