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Economics Weekly - Is a bubble developing in commodities? Weekly economic data preview - US Fed likely to cut interest rates, but signal a hold thereafter

Economics Weekly 28 April 2008

Is a bubble developing in commodities?

Commodity prices have risen sharply…
It may be strange to be worrying about where the next bubble may come from when we are not yet in the clear from the latest one, which is still unwinding in credit markets. But that is exactly what is causing concern amongst some commentators currently, based on the startlingly sharp rise in a range of commodity prices in the last year or so. These increases are not just in gold or oil but also in metals and in a range of agricultural foodstuff. How worried should we be? The headline evidence would suggest that there is certainly a lot to be concerned about.

…leading to worries about a bubble…
Oil prices have doubled, so has the price of gold, copper, wheat and a range of other commodities, all within the last 12 to 18 months. Charts a and b illustrate the scale of this rise. In fact since 2005, industrial metals prices have risen by 350%; crude oil is up nearly 400%, food prices are up by around 250%, with wheat, corn and soya prices rising by at least that rate. It is causing concern about whether price inflation will accelerate back to the sort of levels seen in the 1970s and 1980s, and about hunger and famine amongst the poor that in some places have already led to riots and deaths.

…and increasing price inflation…
But how can this rise in commodities be occurring at the same time that the global economy is supposed to be at threat from the credit crisis; surely that should be causing price falls not price rises? The answer in our view has three main elements; the first is that the credit crisis is hitting only a part of the world economy, and not the fastest growing part of it either, so demand remains strong, thus pushing up commodity prices. The second point is that supply constraints are playing a role, like more acreage being turned over to producing ethanol rather than food, bad weather and crop disease. The third is that worry about supply and subsequent price rises may be leading some exporters to hoard and take goods off the market or importers to buy ahead, so pushing up the current price. However, the worry for many is that the rise is not mainly down to the factors just mentioned, but have been given the biggest push upward by a greater flow of investment into these commodities, as opportunities have dried up elsewhere and because of investors withdrawing from credit instruments after recent losses.

…but there is little evidence of a bubble
Our view is that there is little or no evidence to support the view that it is investment flows that have primarily driven up commodity prices or that there is a bubble developing. It is true that more funds have been set up to invest in commodities, creating more liquid markets in goods that are now in much greater demand, but no signs of the trillions of dollars that drove the credit cycle or the dot.com boom in the 1990s. Further, there is little to suggest that these markets are in bubble territory anyway, i.e. a situation in which prices are so far above fundamentals or their own long run performance as to be unsustainable.

In real terms, commodity prices are below their highs
Chart c, we believe, shows quite clearly that real commodity prices are not exceptionally high. Indeed, in these terms, prices of most commodities have not risen in the last 30 years. Even oil prices, now hovering a little below $120 a barrel, are only just reaching the 1980 high in real terms. Metal prices are roughly back to their 1980 peak, but have been well below it for most of the period 1980 to 2005. Food prices generally are still well below their peak in 1980 and are just back to their 1995 value. What this means is that food prices, one of the biggest areas of concern, have the potential to rise much further if the example of other commodities are a guide. This is especially the case if the response of governments around the world is to restrict food exports. This would drive down food prices in the countries that restrict it and make their farmers poorer, but also drive up global prices. Paradoxically, that would actually increase hoarding, since farmers in countries where exports are restricted would have an incentive to try and get it out of the country to obtain higher prices elsewhere and certainly to sell less food in the domestic market.

In the long term, lower barriers to trade in agricultural goods would increase supply, keep down
prices and boost global growth

Instead of restricting exports, what should happen is that there should be lower barriers to international trade in agriculture. Higher food prices should give a push to the world trade talks currently underway to open agricultural markets and reduce subsidies, especially in Europe and the US but also in some large emerging markets, like India. This would have the effect of boosting farmers’ incomes in poor countries, increase their incentive to plant more and so boost world economic growth. What commodities are not though, are in a bubble.
Trevor Williams, Chief Economist, LTSB Corporate Markets

Weekly economic data preview W/c 28 April 2008

 

US Fed likely to cut interest rates, but signal a hold thereafter

Data in the week ahead are likely to show that the US economy weakened further in Q1 but not into negative territory. However, this will not stop the Fed from cutting interest rates on Wednesday, to 2%, a cumulative reduction of 3.25% since the peak last year. A weakening labour market, worries about consumer spending and the fallout from the credit crisis have forced the Fed’s hands, despite concern over inflation. Concern about the latter will lead to some dissent within the Fed about how much further to cut, and the press release should give some guide to this. Meanwhile, the ECB is signalling more clearly than ever that it is determined not to cut interest rates, even though there are some signs that the economy is weakening. However, concern about inflation is greater than about growth and data this week will highlight the fact that labour markets and industrial output remain resilient. In the UK, declining house prices again feature, with consumer confidence likely to remain weak. At the same time, M4 money supply growth and levels of mortgage and credit borrowing remain historically high.
Further cuts in
UK base rates depend on how much more the economy slows.

• The Fed is likely to cut interest rates again on Wednesday, to 2%, taking them down to the lowest level since December 2004. Data this week, house prices and consumer confidence on Tuesday, and labour market data on Friday show, that the forces of weaker activity ahead are still very strong. On the Shiller basis, house prices are down 11% in the year - though by less on other measures - and consumer confidence has plummeted to levels associated with falls in non farm employment each month of around 75,000. High levels of housing stock in relation to demand and weakness in housing starts and permits suggest that house prices will fall further before stabilising. This supports the likelihood that the Fed will keep cutting rates below 2%. However, other data this week, personal income and spending and manufacturing data, will show that not all parts of the US economy are fading away. The ISM manufacturing index may remain close to 48, signalling expansion in output, helped by the weak dollar and continued strong growth in overseas emerging markets. But the NFP outturn should show a fall of around 50,000, as the economy is growing below trend. Overall though, data suggest the downtrend is bottoming out and rate cuts are either at an end or close to one.

• In the Euro area, manufacturing activity due on Friday, and signalled by a solid above 50 PMI reading, suggests that growth has weakened but may be bottoming out. Consumer confidence, due for Germany on Monday and the EU on Wednesday, has weakened a little, as has industrial confidence. But labour market data are still likely to show that unemployment remains low, helped by export industries that are benefiting from strong world demand. But inflation pressure will be shown in the CPI for the EU on Wednesday, which at 3.6% is well above the ‘2% or below’ target of the ECB. Moreover, producer prices are still rising strongly, suggesting that inflation is building. With these set of figures, the ECB is unlikely to signal a cut in rates. Indeed, the biggest risk in our view is a rise next year.

• UK data this week will highlight that housing market weakness will be a feature of the year ahead, with prices down and approvals and lending likely to be lower. Consumer confidence in consequence has weakened, although employment remains high and unemployment low. The GfK on Wednesday may show little change, in our view. M4 broad money growth overall remains high, implying that asset prices will not collapse, and supporting the strong rise in the footsie in recent weeks. After a fall back, the resilient retail sales figures of recent months may prevent a further fall in the CBI distributive trades’ survey, on Tuesday. With a weaker pound and export opportunities from some overseas markets still good, the manufacturing PMI for April may only fall modestly.
Trevor Williams, Chief Economist, LTSB Corporate Markets

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