How a Rise in Commodity Prices Could Signal Inflation

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Inflation is a devastating economic condition. The value of goods increases while traditional currencies or paper money falls in value on a relative basis. Inflation has not been a problem in the global economy since the financial crisis of 2008. In fact, the opposite had been the case.

From 2008 through 2015, central banks and monetary authorities around the world slashed interest rates and instituted policies of quantitated easing.

Quantitative easing is a monetary tool whereby countries purchase sovereign (and in some cases corporate) debt issues to keep rates of interest low. Central bank policy had been an attempt to increase borrowing and spending and inhibit savings to stimulate lethargic economic conditions.

Economic Lethargy Led to Lower Commodity Prices

In response to a global economic slump, the demand for most raw materials declined. Commodity prices entered into a bear market whereby prices moved lower from 2011/2012 until late 2015 and early 2016.

The price of crude oil dropped from over $100 per barrel in mid-2014 to lows of $26.05 on February 11, 2016. Gold declined from highs of over $1920 in 2011 to lows of $1045 per ounce in late 2015 and silver slumped from over $49 to under $14 per ounce over the same period. Copper plunged from over $4.60 per pound to under $2, and other metals; ferrous and non-ferrous went along for the ride lower.

Shipping activity declined with the Baltic Dry Index cascading to the lowest level in history in February 2016. Commodity prices had been in a secular bull market from 2002 through 2011 and the response to weak economies around the globe caused a massive correction in the market across the entire raw material sector.

Central bankers grappled with weak domestic economic conditions in their respective nations, the rate of inflation fell below target rates. In the United States, the economy began to grow at a moderate pace; quantitative easing came to an end, and the prospects of higher short-term interest rates caused the U.S. dollar to rally starting in May 2014.

A Strong Dollar

The dollar is the reserve currency of the world given America’s position as the world’s leading economy. There is a historical inverse relationship between commodity prices and the dollar, so as the dollar rose when compared to other currencies, commodity prices continued to fall. Raw material prices reached multi-year lows in late 2015 and early 2016.

A high dollar and the continuation of a weak global economic landscape weighed heavily on demand for commodities. At the same time, the bull market in commodities that came to an end in 2011/2012 created huge inventories of raw materials. A combination of big stockpiles and declining demand resulted in lower lows for the prices of commodity staples.

Meanwhile, the U.S. Federal Reserve increased interest rates for the first time in nine years in December 2015 and promised three to four more rate hikes in 2016.

However, the U.S. monetary authority stood alone. In Europe and Japan, interest rates continued to move lower and into negative territory, an unprecedented event. The European Central Bank expanded its quantitative easing program to include corporate debt issues.

China's Role

China, a nation that has been the demand side of the fundamental commodity equation for years if not decades, has seen a slowdown in economic growth. China’s population of over 1.3 billion people and the nation’s incredible growth rate over past years caused the Asian economic powerhouse to consume what seemed an ever-increasing amount of raw materials. However, the recent slowdown in China reverberated around the world causing volatility across all asset classes.

The Chinese government rolled out a new initiative or a ‘new normal’ where the government acknowledged slower growth but pledged stability at lower levels.

A series of currency devaluations of the yuan followed. Commodity prices declined as the prospects for continued Chinese demand at levels seen over past years ebbed. 

Commodities Stage a Rebound in 2016

In response to a combination of European and Japanese continued economic woes, low interest rates and quantitative easing, and a ‘new normal’ in China, the central bank in the United States decided that the potential for economic contagion from abroad rose dramatically over the first six months of 2016.

While the Federal Reserve prepared markets for more interest rate increases, over the first half of 2016 the U.S. central bank left interest rates unchanged. While the dollar initially fell from over 100 on the U.S. dollar index futures contract to lows of just under 92 in response to a continuation of low dollar rates, it stabilized around the 97 level in late July 2016. The stronger dollar was not so much a reflection of a strong U.S. economy but an indication that the dollar is a stable currency when compared to other major currencies around the world that are weak.

Gold Moves Higher

One of the most unusual signs in 2016 has been the action in a commodity that has traditionally served as a currency or a mean of exchange for thousands of years. Gold is both a commodity or metal and currency. As a foreign exchange instrument, gold is a valuable asset held by central banks around the world. These monetary authorities classify gold as a foreign-exchange asset. Over recent years, the central banks of the world have increased their holding of the yellow metal on a net basis. The biggest increases in gold holdings have come from China and Russia.

In dollar terms, gold moved higher from the beginning of 2016, even when other commodity prices were heading to the lowest levels in years. However, gold has moved higher in dollars and all other currency terms in 2016 which has been an ominous sign the global economic landscape. The rise of gold in the face of all currencies tells us that all paper money has lost value when compared to the price of gold. Paper money has the backing of the full faith and credit of the governments that print the exchange notes. The action in the gold market could be providing an ominous sign for the future economic condition of the world. It is telling us that faith in the governments that print money is on the decline.

Commodity Prices Rally

Perhaps taking a signal from gold, other commodities prices staged impressive rallies starting in February 2016.  Crude oil moved from $26.05 in February 2016 to over $50 per barrel by June and remained north of $40 per barrel at the end of July. Copper moved from under $1.94 in January 2016 to over $2.30 per pound by March and was above the $2.20 level at the end of July. Silver rallied to above the $20 level, and almost all other commodity prices moved higher off their multi-year lows.

Currency Debasement

The term for a general decline in the value of paper currencies is debasement. The debasement of currencies means that the purchasing power of the dollars, euros, yen and other major currencies of the world have decreased. It now takes more of these currency notes to buy an ounce of gold, a barrel of oil and many other currencies than it did in late 2015 and early 2016. Although the dollar remains high in contrast to other currency prices, interest rates around the world remain historically low. There is a historical inverse relationship between raw material prices and interest rates. That is because lower interest rates make it less expensive to hold commodity inventories.

Will Inflation Resurge?

The central bank policies of artificially low interest rates and quantitative easing have created an environment where commodity prices have begun to appreciate. It may be early days, but the action in commodities since early 2016 could be a harbinger of an inflationary surge as a backlash of central bank policies since 2008.

The value of paper money declined over the first half of 2016 and if this trend continues the central banks of the world could be facing a far greater problem, a resurgence of inflation. Each and every one of us will experience the effects of inflation on a daily basis as it will cost us more to purchase staples. If these market signals turn out to be a decisive turn in the global economy rather than a short-term correction in commodity prices, individuals, companies and governments could wind up facing runaway costs which may create yet another economic crisis in the months and years ahead.