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According to the US Fed and the Bank of England (BOE), the outlook for the economy remains highly suspect. However, it also seems as if the BOE, the US Fed and a long list of commodity markets are starting to catch a whiff of inflation. For some, the combination of ongoing slowing and rising prices fosters fears of stagflation. The central bankers who are tending toward the use of extra quantitative easing probably want to play up the prospect of deflation, as that seems to give them more room and justification for their actions. While some might suggest that historical rallies in cotton, sugar, coffee, corn, soybeans, beef, gold, silver, platinum and copper could be the result of internal fundamental supply and demand conflicts, there haven’t been many times in history that such a broad-based and historically significant rally ended up being a fluke. Certainly the run-up in gold is somewhat suspect because of the speculative component that is assumed to be in place in that market, but with so many unrelated and usually uncorrelated markets rising at one time, one could come to the conclusion that commodity supplies really are tight enough to push prices up, even in the face of a suspect global economy. We have banged the drum for some time on our belief that many commodity prices are too cheap or too close to their costs of production. It is now becoming even more apparent that global demand can draw down supplies very quickly.
In markets like grains and exotic foods (the soft commodities) it is also becoming clear that even minor supply-side setbacks have become significant events. Washington and the regulators would like to suggest that prices are being inflated by speculation, but that still doesn’t take into account that the cost of production for almost all commodities has risen. The speculators see that, and that is what is pulling money toward commodities. If commodity prices aren’t lifted by speculation, commodity production and supply won’t rise fast enough to meet surging global demand. As recently as June of this year corn prices for 2011 delivery were trading close to their cost of production. With the world supply set to contract even in the face of a record 2010 crop, it was clear that corn needed to rally aggressively or it would risk losing production area to cotton, soybeans or perhaps even wheat.
In the gold market one noted analyst recently suggested that the cost of production at some South African gold mines might be more $900 per ounce. That in by itself suggests that $1,270 gold prices are not as expensive as many would like to think.
An example of a storm brewing in the future can be seen in the milk market, where the price paid to farmers was so cheap throughout 2008 and 2009 that the US dairy industry saw a massive contraction. Since the demand for milk continues to increase globally, the contraction in the US dairy herd will probably means that prices in the coming year will have to explode. Since the dreaded speculators don’t usually frequent the milk market, that potential crisis will continue to fester until the required response in the market serves to reduce demand and rebuild production.
In the meantime, we think that strength in industrial and food-based commodities are justified but that a combination of a sharply weaker Dollar and promises of more easing are destined to bring about a temporary bubble in prices. However, the trend in prices over the long turn probably has to stay up to secure needed supplies. Therefore traders should adopt a long futures mentality, with the addition of periodic options protection in the face of classically overbought technical signals.
