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Inflation And Commodities – Seeking Alpha

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Commodities prices have moved higher, as an asset class, since reaching lows in late 2015 and early 2016. Over recent months we have seen many raw material prices trend to the upside. In the cases of lumber and palladium, we have witnessed all-time highs in late 2017 and early 2018. Copper has moved from $1.9355 per pound in January 2016 to its most recent high at $3.3220 in late December and is currently trading at around the $3.15 level. Crude oil moved from $42.05 per barrel on June 21 to highs of $66.66 on January 25 but has since slipped back to the $59 level. Gold reached its most recent high at $1370.50 on the same day crude oil made its high. Gold’s peak was just $7 below the 2016 high. When it comes to many agricultural commodities, prices have been trending higher for the past two decades as demographics have served to increase technical support levels. In the world of commodities, on the demand side of the fundamental equation, more people with more money continue to compete for finite raw materials.

Commodities prices tend to barometers of inflationary pressures. Meanwhile, one of the biggest short-term support factors for the commodities sector since the start of 2017 has been the trend in the U.S. dollar.

In 2017, the dollar supported commodities prices

2017 started as a scary year for commodities bulls as the dollar came out of the gate at highs and traded to the highest level since 2002 on the dollar index at 103.815. However, the greenback reversed and spent the rest of the year moving to the downside, and three interest rate hikes by the Fed and economic growth did nothing to deter the fall of the dollar.

Source: CQG

As the weekly chart of the dollar index highlights, after trading at its high in January, the U.S. currency spent the rest of the year falling like a knife. The index fell below the 100 level in late January and took out technical support at the May 2016 low at 91.88 in late August. The index closed 2017 at just below the 92 level, and on January 25 it fell to the lowest level since 2014 at 88.255 on the March futures contract.

On the day that the dollar made its most recent low, crude oil traded at its high at $66.66; gold moved to just over the $1370 level. As the dollar headed lower, many raw material prices moved higher. Industrial commodities made the most impressive gains, while bumper crops weighed on many agricultural raw materials. However, in a sign of strength for the grains and soft commodities, despite enough supplies to feed the world and swelled inventory levels, the lower dollar combined with demographic factors led to higher lows. In many agricultural markets, prices have been making higher lows for two decades or longer in a sign that more people with more money are competing for finite raw materials. When it comes to industrial commodities, economic growth has supported prices, but the weaker dollar was a significant factor when it came to higher commodities prices.

Risk-off has caused some corrections over recent weeks

At the end of January and in early February, stocks suffered their biggest correction in years. Volatility has finally returned to the equity markets, and daily trading ranges have increased dramatically over recent sessions. Commodities traders have lots of experience with markets that take the stairs higher for long periods and then, all of a sudden, take the elevator to the downside. The sharp corrective behavior in the stock market caused waves of fear and uncertainty to possess investors and led to some risk-off action as they ran to cash as a safe haven.

During the recent risk-off period in markets, some commodities prices moved lower in sympathy with downside volatility in the stock market. The price of gold moved from $1370.50 on January 25 to lows of $1309 on February 8. Silver fell from $17.705 on January 25 to lows of $16.13 on February 9. Crude oil has corrected from $66.66 on the day that gold and silver made highs to settle at $59.19 on February 13 after trading to a low of $58.07 on February 9. Copper declined from $3.25 to just over $3.00 on February 9, before recovering to $3.16 on February 13.

All of the action in commodities have something in common. They all rose to highs as the dollar fell to its low and recovered as the greenback pulled back over recent sessions. Commodities are trading tick-for-tick with the dollar, but they also are looking over their shoulders at the action in the interest rate markets.

Higher rates mean the cost of carry increases

The recent decline in the bond market triggered selling in stocks, but it also lifted the dollar for a while and weighed on commodities prices.

Source: CQG

The long-term monthly chart of the bond market displays the significance of the recent move that took bonds lower and interest rates higher. The 30-year U.S. Treasury fell below critical support at the 147-07 level in late January and continued to decline in early February. When it comes to commodities, lower bonds and higher interest rates increases the cost of carrying inventories which often leads industrial consumers to sell off stockpiles and purchase requirements on a hand-to-mouth basis. Higher rates also increase the cost of carrying a speculative long position which often deters buying in many raw material markets. Higher real interest rates tend to have a bearish impact on commodities prices. However, sometimes bonds fall, and rates rise because of inflationary pressures, which could have the opposite effect on raw material prices.

Higher rates signal inflationary pressures

Inflation eats away at the value of money, and when rates increase because inflation is rearing its ugly head, commodities price tend to move to the upside. While the memories of the global financial crisis of 2008 have faded in the markets rearview mirror, the tools central banks employed to fight the potential of a recession or worse could have a high price. The past decade saw the Fed, ECB, and other central banks around the world slash interest rates to historically low levels. In the U.S. the Fed Funds rate fell to zero percent, and in Europe and Japan, short-term rates dropped to negative territory. Both the Fed and ECB used quantitative easing to keep interest rates low for further maturities which resulted in a put option on the bond market which encouraged buying. In 2014, the U.S. ended its QE program, and rates have been rising since December 2015. However, accommodative central bank policies continue in Europe and rates remain at negative forty basis points. Given positive economic data, it is likely that the ECB will reverse and start to tighten credit sooner, rather than later in 2018.

Meanwhile, the artificially low rates and QE programs flooded the system with unprecedented amounts of cheap capital. The policies that commenced in 2008 were an attempt to stimulate or inflate economic conditions. The long-term effects of the central bank actions could turn out to be an inflationary backlash. The potential for rising inflation, which eats away at the value of money, has been the reason why stocks corrected sharply over recent sessions. If we are moving into a period where inflation starts to rise above central bank target rates, and they find themselves behind the curve when it comes to short-term monetary policy, it would create a highly bullish environment for the prices of commodities.

Commodities prices thrive in an inflationary environment

I began trading commodities in the early 1980s and those who taught me the business always used the inflation of the late 1970s and 1980 as an example of how volatile and wild a bull market in commodities could become. If we are on the verge of an inflationary spike, commodities will likely be the asset class that does the best. Central bankers say that a bit of inflation is good for economic conditions. However, the last thing they wish to see is raging inflation that makes managing economies like riding a psychotic horse through a burning barn.

The recent break in the bond market through critical levels of technical support, selling in stocks, and a dollar that refuses to do anything but offer a lethargic bounce could be signaling that inflation is coming back with a vengeance. If we are on the verge of an inflationary spike, commodities exposure could hedge or enhance your portfolio. The most liquid commodities ETF product is the DBC with $2.50 billion in net assets. Over recent sessions, the DBC has declined from over $17 per share to around the $16.26 level. However, net assets have increased in the ETF which is a sign that money is moving into the commodities sector. On February 13, over 3.3 million shares of the DBC traded which was almost three times average daily volume in the liquid instrument.

Source: CQG

Since 2006, DBC has traded in a range from lows of $11.70 to highs of $46.63. At $16.26 on February 13, the ETF is a lot closer to lows than highs. If we are entering a period of increasing inflationary pressures, DBC will likely appreciate over the coming weeks and months. I believe the weak dollar, lower bonds and higher rates, and a teetering stock market creates a potent bullish cocktail for commodities prices. However, it is possible that increased volatility in markets across all asset classes will result in risk-off periods. I am a scale-down buyer of DBC and other commodities-based instruments as I believe that offer some of the best upside opportunities for 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.