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Forex Market News - Economics Weekly: Commodity prices rise as world growth remains strong; Weekly economic data preview: Interest rate decisions dominate this week

Economics Weekly

Commodity prices rise as world growth remains strong

Global economic growth was above 5% last year; the third year in a row that is has expanded above this rate. The current boom in the world economy is having many effects, unleashing forces of reform and conservatism and change in political and social spheres in countries around the world. Rapid global growth is also changing the relationships between developed countries and the developing countries, as the latter grow 2 to 3 times faster than the developed countries. Moreover, the full range of industries and occupations are impacted in different ways and to varying degrees by this fast growth, including financial markets. It is the impact on the demand for commodities, especially foodstuffs, which we shall concentrate on in this briefing.

Commodity prices have been booming due to the demand from emerging market economies…
Strong demand from the industrialising countries, and from the developed countries that have also seen strong growth in the last few years, has led to huge increases in the prices of metals and industrial materials, see chart a. Metal prices like, zinc, copper and lead are 260% higher than they were in 2005. Industrial metals used in final manufacturing processes are up by 40% and energy prices are up twofold. But the chart suggests that the index of foodstuffs prices has barely budged. However, the headline index is misleading, as it is being compared with the meteoric rise in the other commodities, and some food prices have really taken off. Our analysis shows that so called soft commodities – agricultural foodstuffs - are also now responding to stronger global demand from fast growing parts of the world and from changing tastes as their populations get richer and diets improve and change. One change already evident is that demand for meat is rising as incomes rise (to be expected), and this is now impacting livestock prices, as shown in chart a.

…but food prices have been left behind, until now...
So, which food prices are showing the strongest rise? Chart b shows that soyabeans, used in vegetarian meals and in a range of other food products, are up by 60% from a year ago. Chart c shows that cocoa prices are up by 50% from their 2005 lows; chart d that corn prices are up by 130% over the same period; chart e that wheat prices have doubled; chart f that barley prices have doubled and chart g that coffee prices have increased by 50%. Some of these increases are related to bad weather, like coffee, but the trend is the same for all them: upward because of increased demand. How far can these increases go? Unlike for most metal prices that are pushing up against all time highs in real terms (that is, adjusted for inflation over time) many food prices are still well down on their all time peaks. This suggests that there is scope for further increases. But it also suggests that there are risks for overall consumer price inflation. As chart h shows, food prices in the UK’s consumer price index are now rising by over 6% a year, after rising by between -0.3% and 2% for two years prior to that. This is bad news for average interest rates going forward, as it implies that they will have to be higher on average in the next few years compared with the previous period when food prices were sharply lower. offer potentially competitive returns to investors compared with other investments
It is worth bearing in mind though that there are other factors leading to stronger demand and so to higher prices for foodstuffs. One is demand for bio fuels, which is strongly driving demand for sugar and corn. There are signs that the high oil price will lead to rising demand for both of these as substitutes for as long as oil prices remain elevated. Greater demand for cattle is also feeding demand for some foodstuffs, as it is also used for feed, especially barley and corn. Eventually, we believe that more land will become available for food production but for some indeterminate time these prices are likely to remain high. In our opinion, this should put pressure on trade negotiators around the world to push through the Doha world trade talks, which concentrates on freeing up agricultural markets. This would lead to lower food prices for consumers in rich countries and lower consumer price inflation and so lower than otherwise interest rates. From an investment perspective, all of this may take time and, in the interim, many of these foodstuffs are likely to see continued strong upward price pressure, as we look for global growth to stay strong, and so offer potentially competitive returns to investors compared with other investments.
Trevor Williams, Chief Economist

Weekly economic data preview
Interest rate decisions dominate this week

• We do not expect any interest rate surprises this week: the BoE is set to keep Bank rate at 5.5% on Thursday, the ECB will raise interest rates to 4% on Wednesday and the RBA should keep the cash rate at 6.25%. The most confident call is that of a hike from the ECB.

• We expect the Bank of England to keep Bank rate at 5.5% this week, even if the decision to do so may not be unanimous. However, the fact that it is likely that at least one member of the MPC may vote for a successive monthly hike means there is still a small chance of a surprise. A stronger than expected services PMI on Tuesday could raise market tensions ahead of the decision on Thursday.

• In a change to the norm, the ECB interest rate decision is due on Wednesday this week. Interest rates are expected to rise to 4%, as signalled clearly at last month's press conference. The focus will then turn to the press conference and ECB president Trichet's comments, with continuing robust data making the prospect of further monetary tightening later in the year increasingly likely. Data this week should continue to reflect solid growth, with another strong set of services PMIs expected and a further rise in EU-13 retail sales, following on from a robust German retail report last week.

• The Reserve bank of Australia is expected to keep interest rates steady at 6.25% for a sixth straight meeting early on Wednesday. But solid growth suggests pressure for a rise may build.

• US data this week are likely to add to a run of data confirming our view that interest rates will stay on hold all year. The non-manufacturing ISM should show continued expansion in May and the trade deficit may have narrowed slightly in April after a surprisingly sharp rise in March.

This week is too soon for the Bank of England (BoE) to continue on its current tightening cycle, although recent data have slightly raised the chances of a hike to 5.75% sometime in the coming months. Survey reports of companies raising or intending to raise prices last week will resonate with the concerns highlighted by the MPC in the minutes of the May meeting and the Q2 Inflation Report. However, other data, such as continuing subdued earnings growth and signs of a softening in housing market activity, may help to temper some of their fears.

The fact that a 0.5% rate hike was considered at the May MPC meeting suggests that unless economic growth shows clear signs of slowing or inflation falls rapidly in the months' ahead, base rates will rise in a few months. The main argument against a hike this week is that the MPC only last month raised interest rates to 5.5% - a six-year high – and the fourth increase since August 2006. The minutes of the May meeting showed that some members were already concerned about the downside risks posed to growth and inflation of any excessive movement in rates and others felt that given the large degree of uncertainty around both the outlook for inflation and the impact of interest rate changes, it was better to move cautiously. Indeed, one of the main reasons for not raising interest rates by 0.5% last month was that the committee felt that they had to be confident about the need for another rise soon, suggesting that another hike in June was not on their agenda. Nevertheless, the MPC has surprised the financial markets before and, given that it is unlikely that the vote will be unanimous in any direction, it would be foolish to ignore the small risk of a possible hike this week. The services PMI, on Tuesday, could raise tensions ahead of the decision, if it comes in much better than expectations. Anecdotal evidence suggests activity remains buoyant and a strong rise would not be a major surprise.

The ECB will raise interest rates to 4% this week, in line with the 'coded' message from president Trichet last month. Although data have remained robust and financial market expectations of a further hike have increased, president Trichet is likely to remain coy about the prospects for rates later in the year. We remain of the view that interest rates will rise once more this year, in the final quarter, ending the year at 4.25%. Data this week should support this outlook, with services PMIs expected to show buoyant activity in May. After the surprise 2.8% jump in German retail sales last week, EU-13 retail sales are likely to have risen in May.

It is a relatively quiet week for market-moving data from the US. The non-manufacturing ISM, on Tuesday, should hold close to 56, the level reached in April. The prices paid index will also attract attention. The trade data for April are published on Friday and are likely to influence where financial markets close the week. A modest narrowing is forecast, to $62.5bn from $63.9bn in March, on lower imports.
Jeavon Lolay, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500

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