How QE3 changes commodity prices
(The views expressed in this column are the author’s own and do not represent those of Reuters)
On Sept. 13, the U.S. Fed announced the QE3 program whereby it purchases mortgage-backed securities at $40bn per month with no time limit. It also pushed out guidance on keeping a low funds rate to mid-2015 from late 2014.
Officials also maintained a strong bias toward further easing with the labour market, the key determining factor on whether there will be further monetary easing. If employment does not improve, then the Fed is open to more easing to help lower the unemployment rate.
UBS has been bearish all year, on the view that capital outflows out of emerging markets would force companies there to run their businesses for cash and to destock commodities. Until last week’s QE announcement, we had planned to hold that view until credit stress rose sufficiently in the United States to raise deflationary pressure and then to force QE.
However, with the latest move, the Fed has changed the way it operates. The Fed is now using QE to stave off deflation. Bernanke has said the Fed will use QE to speed the approach towards their unemployment target, which we believe is likely to be 5.5-6 pct. This compares to the current unemployment rate of 8.3 pct. This completely changes the game as the Fed is now implementing QE even as U.S. credit conditions are benign, and the S&P is above 1,400.
We believe the QE3 programme would trigger capital flows back to emerging markets. We believe that these capital flows are the most powerful fundamental driver of commodity prices. A key transmission mechanism of capital flows is via corporate incentives. When capital flows into emerging markets and inflation picks up, companies see profits being squeezed by a combination of rising costs, but capex remains high due to inflation and pricing power is weak.
Companies then react by gearing up to build inventories; this is an attractive proposition when real rates are low or negative. The other strategy for companies is to speculate on property due to low or negative real rates. We stress inventory build and both highly commodity intense activities.
In a situation of capital outflows, companies find themselves with thin margins and excessive debt. They are incentivised to raise cash and this is done through either destocking or selling property portfolios. When destocking and selling down property portfolios is combined with broader liquidity tightening, this generates significant fundamental pressure on commodity prices. This is the main reason we have been bearish on commodities this year.
However, QE would trigger a return of capital flows to emerging markets, which would ease liquidity, generating reflationary/inflationary pressure, as well as incentivise a restocking phase.
In China, we have seen significant consumer destocking of copper, and steelmaker destocking of iron ore. There would certainly be scope for a restock under these conditions, aided by the traditional seasonal uptick that takes place from November. Such a restocking of goods and commodities will help pushing up commodity prices.