Hans Christian Andersen’s fairy tale about the “The Emperor’s New Clothes” is a good explanation for the spectacular expansion and implosion of the bubble economy in the 2000s.

For a time, a collective suspension of disbelief allowed markets and investors to ignore risks produced by cheap credit, subprime mortgages, securitisation and the shadow banking system.

The system worked until someone impolitely shouted out the risk had not gone away, it was just hidden in plain sight, and many institutions were insolvent.

But how many people remember how the fairy tale ends?

“‘But he has nothing on at all,’ said a little child at last. ‘Good heavens! Listen to the voice of an innocent child,’ said the father, and one whispered to the other what the child had said. ‘But he has nothing on at all,’ cried at last the whole people.

“That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself ‘Now I must bear up to the end.’ And the chamberlains walked with still greater dignity, as if they carried the train which did not exist.”

The emperor decided it was too embarrassing to admit he had been fooled. But that is where monetary policy and the fairy tale part company.

In a thoughtful article published this week in the Financial Times, PIMCO Chief Executive Mohamed El-Erian and Columbia Economics Professor Richard Clarida explore the implications of a shift in the shape of investors’ and policymakers’ expectations about the future.

“It seems that, wherever we look, the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves — with a high likelihood mean and thin tails (indicating most economists have similar expectations) — to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).”

They do not go quite as far as Bank of England policymaker Adam Posen, who suggested in a recent speech that the distribution of outcomes has inverted and become U-shaped. But their focus on a bell-curve with fatter tails agrees with Federal Reserve Chairman Ben Bernanke’s characterisation of the economic outlook as “unusually uncertain” at present.

El-Erian and Clarida draw five conclusions for investors:

(1) Investment strategies based on mean reversion will become less compelling. Fat-tailed distributions still have means but they will be realised less often in practice.

(2) Frequent risk-on/risk-off oscillations in sentiment will remain a persistent feature of the landscape.

(3) Hedging against tail-risks will become increasingly important.

Russia’s decision to ban grain exports will be welcomed by some physical grain traders because it allows them to declare “force majeure”, walking away from wheat supply contracts that had become increasingly uneconomic to perform.

Force majeure was originally developed as a doctrine under civil law systems. There is no automatic or general right to invoke force majeure in the common laws of England and New York that govern most international commodity supply contracts.

The common law equivalent is “frustration”. Lawyers have spent many happy and profitable hours arguing what does and does not constitute frustration. It is a narrower definition than force majeure — and much harder to prove.

But something similar to force majeure can be incorporated into a contract by the specific agreement of the parties. Lawyers advising commodity traders will always ensure that a carefully worded force majeure (FM) clause is included in every commodity supply agreement to enable the supplier to walk away if the contract becomes too onerous to perform.

The first step is to define the goods to be supplied very carefully. Assume Trader A has contracted to supply wheat to Country B that it intends to source from Country C. If the contract is merely for the supply of “wheat” meeting certain quality standards, an export ban would not enable an FM clause to be invoked.

If Trader A can no longer obtain the wheat as planned from Country C because of an export ban, the court would hold it to the requirement to deliver the wheat, even if that means sourcing from another country D at greater expense, incurring losses, or pay compensation for the failure to perform.

But if the contract defines the goods as “wheat from Country C”, then an export ban renders it impossible to fulfil. Wheat from Country D is no longer an effective substitute for the wheat from County C no longer available.

Total assets under management in commodity-tracking indices and exchange-traded products (ETPs) have stalled over the last nine months, as roll losses swallow up fresh money inflows.

There has been little change in total money committed to index-like investments or its distribution between long and short positions, according to the latest quarterly figures released by the U.S. Commodity Futures Trading Commission (CFTC) yesterday, which show positions as of 30 June 2010.

The data is based on a special call sent to all known index operators and firms offering futures and options-based exchange-traded products. It is the most comprehensive measure of total funds under management in the passive sector, but excludes physically backed ETPs such as the popular SPDR Gold Trust .

Investors had a total of almost $264 billion in commodity indices and ETPs at the end of Q2 2010, down from the $271 billion at the end of Q1, but little changed from the $263 billion reported at the end of 2009.

Investments were split in a ratio of 4.11:1 with $212 billion worth of long futures and options positions and $52 billion worth of shorts. The ratio was slightly more bullish than at end-March (3.95:1) but essentially identical to the ratio reported at the end of 2009 (4.12:1).

In energy, the long/short ratio climbed from 3.88 to 4.37, the most bullish since 2008. But the jump was due to profit-taking by shorts after a profitable period characterised by declining spot prices and a pronounced contango structure in futures markets. On a net basis, there were no new long positions. Investors’ long exposure fell reflecting roll losses. Commodity futures markets have reached equilibrium. Fresh money is still flowing in (evidenced by the fact assets under management have remained steady despite roll losses associated with the contango structure). But inflows have been offset by the contango structure, ensuring little upward pressure on prices.

Much greater switching in the proportion of funds allocated to individual commodities indicates that the investment focus is switching away from indices with fixed weightings towards dynamically re-weighted products or single-commodity indices and ETPs that enable a more active and tactical approach to take advantage of particular trends or futures market structures.

Commodity indices and exchange-traded products (ETPs) should be regarded as short- to medium-term investments rather than long-term strategies, as a quick glance at performance over the last 10 years shows.

Their value lies in providing simplicity and liquidity for retail investors and institutions such as pension funds, which do not want the complexity of managing futures positions with their daily margin adjustments and rollovers.

They also permit institutions and retail investors forbidden from investing in derivatives to gain exposure indirectly by repackaging derivatives as swap transactions or embedding them in structured notes, which resemble debt or equity securities.

But they are really only suitable for implementing tactical and value-based views about the short-term direction of commodity prices over horizons ranging from intraday trading of a few hours to as much as six to 36 months to exploit the economic and commodity price cycle.

Their usefulness deteriorates over longer horizons as the cost of carrying the position outweighs eventual cyclical or secular price gains. “Buy and hold” strategies tend to lose money over the long term.

EXPOSURE TO THE COST OF CARRY

Investors in equities and bonds usually receive dividends and coupons to compensate for the use of their capital (as well as upside participation in capital gains in the case of stock).