The "Commodity Super Cycle" - How long can it last?
Are we in the ninth inning of the "Commodity Super Cycle" that has lifted the Reuters Jefferies Commodity (CRB) price index 91% higher from four years ago to its highest level in 26 years? The Reuters Jefferies CRB index of 19 commodities reached a high of 350.38 on Jan 30th and is comprised of futures in live cattle, cotton, soybeans, sugar, frozen concentrated orange juice, wheat, cocoa, corn, gold, aluminum, nickel, unleaded gasoline, crude oil, natural gas, heating oil, coffee, silver, copper and lean hogs.
Barclays Capital said on January 5th that commodity investments might parlay another $40 billion this year up to $110 billion as pension funds and other money managers diversify from stocks and bonds. Big-money investment funds have boosted their stake in commodity indexed markets to around $70 billion in 2005, up from $45 billion by the end of 2004 and only around $15 billion at the end of 2003.
Pension funds, as well as small, retail investors are looking to commodities as a crucial part of diversification of any investment portfolio. Although schizophrenic commodity day traders could decide to turn massive paper profits into hard cash at a moment's notice, causing a 5% shakeout, the longer-term odds still favor a continuation of the "Commodity Super Cycle, into extra innings.
Central bankers point the finger of blame for soaring commodity prices on China's juggernaut economy, which has expanded at breakneck speed of 10% for each of the past three years, competing with rampant demand for basic resources from big importers like India, Japan, Germany, South Korea, and the United States. India's booming economy expanded 8% and Korea's by 5% last year. China bought about 22% of the global output of base metals in 2005, compared with 5% in the 1980's, and has doubled its crude oil imports from five years ago.
Central bankers stare at the explosive CRB rally from the sidelines with a sense of indifference or stone faced silence, though sharply higher commodity prices are telegraphing higher producer price inflation. Furthermore, China is under daily pressure from the Bush administration to revalue its yuan higher against the dollar, which in turn, would give Beijing even greater purchasing power abroad, and provide more support for a whole range of commodities from crude oil, iron ore, zinc, copper, platinum, uranium, soybeans, and ethanol.
But perhaps, the simplest answer to explain the long term bullish outlook for global commodities boils down to one simple equation. According to the latest population count by the United Nations, the world had 6.5 billion inhabitants in 2005, 380 million more than in 2000, or a gain of 76 million persons annually. By 2050, the world is expected to house 9.1 billion persons, assuming declining fertility rates. In other words, a world of finite raw materials, along with an increasing population base, translates into higher prices.
Until recently, the "Commodity Super Cycle" has been led by base metals such as copper, aluminum, and zinc, precious metals such as gold, silver, and platinum, and higher energy prices led by crude oil and natural gas. Recently however, commodity traders have doubled sugar prices to 24-year highs, and are moving into coffee and soybeans. Other raw materials such as iron ore rose 72% in 2005. Although China is a big exporter of steel, fears of a global supply glut could disappear rapidly, if global steel makers begin a pattern of consolidation, following in the footsteps of the gold mining industry over the past few years.
But how did the Reuter's CRB index reach record levels in the first place? Well consider the Chinese and Indian economies, which also account for one third of the world's population, and the super easy money policies pursued by the big-3 central banks, the Bank of Japan, the European Central Bank, and the Federal Reserve. Both ingredients, when mixed together, make an explosive cocktail that has lifted commodity indexes into the stratosphere.
And a trend in motion, will stay in motion, until some major outside force, knocks it off its course. So not withstanding inevitable profit-taking sessions, what major outside force is out there that could derail the CRB's upward trajectory?
Chinese demand for imports has soared by 330% from roughly $15.5 billion per month in early 2002 to a record $64.4 billion in December 2005. China is the world's fifth largest importer, and bought $632 billion worth of goods in 2005. The world's number-one miner BHP Billiton BHP.AX ran its mines and smelters at full speed in the fourth quarter to capture strong commodities prices, setting the stage for full-year profits to exceed $9 billion. Rio Tinto, RIO.AX, the world's second largest miner pushed its operations harder to double its 2005 profit to around $5 billion.
China's economy overtook France and the Great Britain to become the world's fourth largest last year, and will grow an estimated 9.4% this year. The European Union and Japan expect growth of 1.9% this year. Chinese Premier Wen said on December 1st that China needs to "maintain rapid and stable economic growth to raise the living standards" of the nation's 1.3 billion people, whose per capita income of $950 per year, ranks 129th in the world. Beijing is cutting taxes and raising salaries to encourage more spending on cars and household appliances.
Exports are a key driver behind the Chinese economic miracle, with China's currency exchange controls and trade surplus with the US topping $204 billion in 2005, a 25% increase on the previous year and nearly 30% of the total US deficit. The lynchpin of Chinese exports is the low yuan /dollar exchange rate pegged at 8.11 per dollar, undervalued by 30% to 40% on a trade weighted basis.
The People's Bank of China increased its M2 money supply by 18.3% last year, issuing more yuan to soak up foreign currency earned through foreign trade and direct investment into Chinese factories from abroad. Explosive money supply growth, in turn, boosted domestic retail sales by 13% last year, and industrial production was 16.6% higher in November from a year earlier. China's central bank raised its M2 money supply target to 17% in the third quarter from 15% earlier, to offset stronger demand for the yuan, and maintain the peg at 8.11 per US dollar .
China 's crude oil imports rose 4.4% in the first 11 months of 2005, and are expected to total 130 million tons of crude (2.5 million bpd) in 2005. Crude oil production from China's biggest oil field, Daqing, fell about 3% to 44.95 million tons (900,000 bpd) last year. China, the world's second-largest oil consumer, expects to secure foreign energy supplies with foreign deals for its economy, after it turned into a major oil importer and still suffers from severe power shortages.
China's oil giant Sinopec signed a $70 billion oil and natural gas agreement with Iran, to buy 250 million tons of liquefied natural gas over 30 years from Tehran and develop the giant Yadavaran field. Iran is also committed to export 150,000 barrels per day of crude oil to China for 25 years at market prices after commissioning of the field. Iran is China's biggest oil supplier, accounting for 14% of Chinese oil imports. In return, Tehran's Ayatollah is demanding a Chinese veto at the UN, to shield his secret nuclear weapons program from international sanctions.
India's Prime Minister Manmohan Singh, wants his country to achieve 10% economic growth in the next two to three years, to create more jobs and help lift a third of the country's 1.1 billion people out of poverty. Asia's fourth-biggest economy expanded 8% in the second and third quarters of 2005. Singh's government wants industrial production, which makes up a quarter of India's economy, to grow 10% annually to boost the incomes of Indians, one in three of whom live on less than $1 a day.
India's industrial production grew at an annualized 8.3% rate between April and November 2005, faster than major economies like US, UK, the Euro zone, Japan, Brazil, Indonesia and Russia. Only China and Argentina recorded faster industrial production rates of 16.6%, and 9.6% respectively. On the global sphere, US industrial production grew only 2.8%, and the UK, the Euro zone, and Indonesia, saw declines of 2.4%, 0.8%, and 3.4% respectively in their overall industrial production.
Indian economists have observed an 86% correlation between industrial production and exports. But the Indian export sector does not dominate growth in the Indian economy, such as in China and South Korea. The Indian economy is more about domestic consumer demand, which contributes nearly 70% to GDP, while exports contribute only 15% to India's GDP. India ranked 24th among global importers purchasing $113 billion of goods in 2005, or about a sixth Chinese demand.
Japan is also a major factor behind the rise in global commodity prices, with industrial production rising for a fifth month in December to a record, sustaining the nation's longest expansion in eight years. Japanese industrialists plan to spend 17.3% more on factories and production facilities in 2006 than last year. Overseas sales are also bolstering production and imports of raw materials from abroad. Japan imported $451 billion of goods in 2005, the seventh highest among global importers.
Japan 's exports rose 14.7% in November from a year earlier to 5.9 trillion yen ($50.2 billion), the second highest ever, on the heels of the yen's 19% devaluation against the dollar, and 17% drop against the Chinese yuan. Shipments to China rose 12.8% and those to the US climbed 8.9 percent. Exports were up for the 23rd consecutive month while imports rose for the 20th month in a row.
To meet strong demand from abroad, and an economic revival at home, Japanese imports of raw materials have soared 66% to 5.42 trillion yen per month from three years ago, and in turn, providing underlying support for global commodity prices. Japan paid 20% or more for nonferrous metals, crude oil and coal in 2005, which companies are expected to pass on to customers.
Japan 's wholesale price index was 1.9% higher in November from a year earlier, and has been in positive territory for two years, but the Japanese government claims that consumer prices are just emerging from a seven year bout of deflation. But the Japanese wholesale price index tracks major trends in the Reuters Commodity price index, which has risen 91% over the past four years, for an annualized gain of 23%, much higher than the Japanese wholesale price index of 1.9% inflation.
That would imply that Japanese manufacturers are getting squeezed by sharply higher raw material costs, and unable to pass costs along to intermediaries. Yet, large Japanese manufacturers claim their profits are expected to be 5.2% higher in 2005, and the Nikkei-225 stock index rose 40% last year to a 5-year high. If correct, then profit margins might have been inflated by a stronger dollar against the Japanese yen. That explains why the Japanese ministry of finance is jawboning or intervening in the currency markets, whenever the dollar has a rough day.
Global commodity prices bottomed out in late 2001, soon after the Bank of Japan lowered its overnight loan rate to zero percent, and adopted quantitative easing. The central bank prints about 1.2 trillion yen ($10 billion) per month to purchase Japanese government bonds, inflating the amount of yen circulating around global money markets. More Japanese yen yielding zero percent, chasing fewer natural resources in turn, leads to sharply higher global commodity prices.
The Japanese ruling elite are devaluing their way to prosperity, by flooding the Tokyo money markets with 32 trillion to 35 trillion yen above the liquidity requirements of local banks. The enormous supply of excess yen pushed Japan's 3-month deposit rate below zero percent for most of 2004. With borrowing costs at zero percent or less, Japanese and foreign hedge fund traders have found the cheapest source of capital to leverage speculative positions in global commodities.
And the Japanese ministry of Finance is not expected to grant permission to the Bank of Japan to begin mopping up some of the excess yen until the second half of 2006, at the very earliest. On January 9th, Japanese Finance Minister Sadakazu Tanigaki said, "There is a need for the BOJ to make a careful assessment of data. It should not rush things." The BOJ is certainly not rushing things. It has kept the overnight loan rate pegged at zero percent for five long years.
Kozo Yamamoto, the ruling LDP party chairman on monetary policy matters expressed outrage at the prospects of a BOJ policy change, saying quantitative easing must stay in place to eradicate deflation for good and to keep bond yields low to help the government trim debt servicing costs. "But if the BOJ were to ignore our view and force through the same mistake it made when it ended the zero rate policy in August 2000, ending up with a miserable outcome, we would then revise the BOJ law of independence," he warned.
The European Central Bank cannot ignore the Euro zone's loose monetary conditions and increased risks to price stability, said ECB chief economist Otmar Issing on December 19th. "Money growth has been high for quite some time and credit growth has continuously increased, supporting our assessment of the risks to price stability. Liquidity in the Euro area is more than ample. A central bank with the mandate to maintain price stability cannot ignore these signals," Issing added.
Yet for two and a half years, the ECB ignored a 50% surge in commodity prices, since lowering its repo rate to 2.00% in May 2003. The Euro M3 money supply growth rate was 7.6% higher in November from a year earlier, above the central bank's original mandate of 4.5% growth. Thus, t he ECB's quarter-point rate hike to 2.25% in December was too little, too late, to get in the way of the "Commodity Super Cycle," with the Reuters CRB rising another 10% in its aftermath.
Italian central banker Bini Smaghi spoke with a twisted tongue on the matter on January 25th. "If a central bank stops excess liquidity too late it has to raise rates much more strongly and that causes turbulence on the markets." Then, casting doubt about the ECB's resolve to combat commodity inflation, Smaghi said there are a range of risks to durable economic recovery in the Euro zone. "There are no clear signals about how strong growth really is. That's why we've got to be careful in this early stage of the recovery," Bini Smaghi said.
For the past three years, the ECB pursued a policy of "asset targeting", inflating its Euro M3 money supply to lift European stock markets into higher ground, and through the "wealth effect" lift the spirits of the frightened European consumer. The ECB is running into a barrage of resistance from top European finance officials to higher Euro interest rates, fearful of any action that could undermine the European stock markets. The ECB has much greater political independence than the BOJ.
Sending a clearer signal on January 23rd, ECB economist Issing argued, "Trichet made it very clear. The December rate hike was not the first in a series of steps. But we will always act on time. The risk to price stability has increased in the context of higher oil prices," Issing said, adding that Euro zone consumer inflation, which fell to 2.2% in December, was likely to rise again.
The ECB's Klaus Liebscher also expressed concern that the sustained high cost of oil would feed into wages and prices for other goods and services. "Without a doubt, there is still a large danger," he said, citing the German producer price index, which rose by 5.2% in December, its fastest pace for 23 years. Traders should always trust the hard dollars and cents flowing through the commodity markets for real time indications of future inflation, and not government statistics.
One has to question how the Japanese wholesale price index is only 1.9% higher from a year ago, or roughly 3.3% less than the German PPI, when the yen was 6% weaker than the Euro against the dollar last year. But in an age where ruling parties distort data to serve their own interests, it is hardly surprising that Japan's financial warlords present price indices and inflation data in a manner best suited to their immediate needs. There is simply is no limit to how far the Japanese government will go to keep its borrowing costs down and to protect the interest of its exporters.
Because most commodities are traded in US dollars, the Federal Reserve has a special role to play in the fight against commodity inflation. The Fed must protect the value of the US dollar in the foreign exchange market, with higher interest rates if necessary, to keep the Commodity Super Cycle in check. Yet the Greenspan Fed waited for the Reuters Commodity price index to rise by 45% above its 2001 low, before taking its first baby step to lift the fed funds rate by a quarter-point to 1.25%.
The Fed has moved in predictable quarter-point moves for the past eighteen months, and has signaled that 4.50% could be the peak in the tightening campaign. The Fed is targeting US home prices, which have flattened out in recent months, and should preclude further rate hikes in 2006. Still, the Fed's go-slow approach to combating inflation has left it far behind the "Commodity Super Cycle."
The Greenspan Fed produced a sizeable counter trend rally for the US dollar in 2005, pushing the greenback from 102-yen to as high as 121.50-yen, and knocking the Euro from as high as $1.3450 to a low of $1.1650. However, the Fed efforts to control commodity inflation were completely undermined by the super easy money policies of the Bank of Japan and the European Central Bank.
How would the new Fed chief Ben Bernanke react, if commodity prices were to continue to soar further into the stratosphere? Without the life support of higher interest rate expectations, the deficit ridden US dollar could come under renewed speculative attack in 2006. Especially, after China signaled a desire to diversify an expected build-up of $200 billion of foreign currency reserves away from the US dollar this year. A weaker dollar could give commodity prices extra support.
Fortunately for commodity bulls, Bernanke doesn't believe there is a link between a higher CRB index and higher producer price inflation. On February 5th, 2004, Bernanke said, "rising commodity prices a variable of growth rather than inflation." Then on May 24, 2005 Bernanke played down worries about higher energy and commodity prices. "Much of the recent price gains in energy and commodities reflect the rapid growth of the Chinese economy. Chinese authorities are now trying to slow that growth, and should help check the growth of commodity prices," he said.
Bernanke has also rejected opinions that the recent rise in oil prices is largely a symptom of super easy central bank monetary policies. "The consensus that emerges from this literature is that the relationship between commodity price movements and monetary policy is tenuous and unreliable at best. Moreover, recent experience doesn't support the notion that monetary policy had a substantial effect on the oil price rise," he said.
Then on October 25, 2005, the day after his nomination to lead the Federal Reserve, Bernanke was asked again about soaring commodity prices and their impact on the inflation outlook. "The evidence seems to be that it is primarily in energy and some raw materials and has not fed into broader inflation measures or expectations. My anticipation is that's the way it's going to stay."
Most likely, Bernanke would continue to ignore a surge in commodity prices, but keep a close eye on US home prices. Any sign of a significant downturn in US home prices, could quickly prompt the new Fed chief to lower the fed funds rate. Already, home re-sales in the United States fell 5.7% in December to the lowest level since March 2004, after five years of gains that shattered construction and sales records and sent prices up more than 55% nationwide. The national median sales price in December was $211,000, and down from a record high of $222,000.
The Greenspan Fed was an "Asset Targeter" and inflated US home prices over the past few years to offset huge losses in the Nasdaq and S&P 500 stock indexes. The Fed borrowed this strategy from the Bank of England, which pioneered home price targeting in 2001. By moving in baby step quarter-point rate hikes, the Fed was careful to avoid a meaningful downturn in the housing markets, until signs of froth in home prices were sprouting in over 100 major US cities in late 2005.
Any sign of potential weakness in the DJ home construction index towards the horizontal support at the 800-level, could be met by aggressive half-point rating cutting by the Bernanke Fed to head off an implosion of consumer wealth and confidence. A significant decline below the 800 level could signal a head and shoulders top pattern to technicians, projecting a decline to the 550-level. Fortunately, head and shoulder pattern rarely work anymore, and usually just set bear traps. Sharp rate cuts by the Fed might bring Wall Street investment bankers to the rescue of the housing sector.
So what could derail the "Commodity Super Cycle" in 2006? Schizophrenic speculators could be tempted to lock in profits at a moment's notice. But big time players like China, Japan, and India could provide a safety net for falling commodity markets, gratefully locking in lower prices for raw materials. Beijing is on course to reach $1 trillion of foreign currency reserves by years ahead. Base metal and precious metal dealers could be loathe to offer big discounts to cash rich Beijing.
China is still holding a massive short position in copper futures, estimated at below 200,000 tons because of positions amassed by trader Liu Qibing. Yet there are only 140,000 tons of copper in publicly reported stockpiles worldwide, equal to about three days of global usage, and stored in warehouses monitored by the London Metals Exchange and commodity exchanges in New York and Shanghai.
The Bank of Japan is aiming for negative interest rates by forcing the "core" inflation rate to rise above its zero percent overnight loan rate, before moving to tighten its monetary policy. Negative interest rates would actually produce an easier money policy in Japan in the short term, and possibly create a major bubble in the Nikkei-225 stock index. The ECB's baby step rate hike campaign would probably fizzle out near 2.75%, hardly enough to scare anyone. And the Fed's Bernanke is on guard against falling home prices.
Crude oil is hovering near record highs, fearful that Iran's Ayatollah might unleash the "Oil Weapon" in 2006, squeezing crude oil to $80 per barrel, if Europe and the US muster the nerve to impose economic sanctions on the Islamic regime. A battle in the Strait of Hormuz could disrupt oil supplies and the supply of commodities worldwide. But high-flying Asian and European stock markets are betting the Ayatollah will flinch at the eleventh hour to avoid a military showdown with the US and NATO, and wipe out a $10 per barrel "War Premium" for crude oil.
Weighing all the bearish and bullish arguments however, it appears likely that the "Commodity Super Cycle" is bound to go deeper into extra innings and reach new frontiers in un-chartered territory.
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