Red-Hot Inflation Now Baked in the Crust

“Wall Street and the City are suddenly piling into the commodity markets. Expect a side order of ’70s style inflation to hit your dinner table as a result.”

DIG OUT YOUR BELL-BOTTOMS and dust off your Doobie Brothers albums! This is where inflation stops hiding behind the official CPI data…and starts eating your cash savings and income alive.

“More Fund Investment in Agricultural Markets in 2008,” says Lehman Brothers, now launching a “Pure Beta Index” to buy long-dated futures in 20 soft commodities…

“Funds’ Take-up of Commodity Indexes to Rise 20%,” says the Financial Times, quoting Eric Kolts at Standard & Poor’s. Global pension fund investment in commodities will reach $160 billion, he believes, in 2008…

“Energy and Commodities May Avoid Banks’ Job Ax,” adds the San Diego Union-Tribune, quoting an analyst saying that “Commodities and energy has been a massive push for everybody.”

“Banks will look to retain expansion plans in commodities, which is seen as a growth area,” agrees a senior U.S. executive…

Across the Pond here in London comes the Wessex Gold Fund, using leverage to go long/short of gold mining equities and give itself “an additional edge versus long-only alternatives.” That edge will cost anyone making the minimum $500,000 investment — with a minimum 12-month lockup — some 1.5% in annual management fees, plus a 20% grab off any gains they might make…

Down Under in Australia, Oceanic Asset Management is launching “a stable” of commodity investment funds at the start of November, looking to nab both retail and institutional money. It’s starting with a $710 million equity fund based in London, plus an offshore hedge fund in the Caymans…

And UBS, meanwhile, just announced the launch of its Commodities Portfolio Algorithmic Strategy System. Nicknamed the UBS Comm-PASS, it’s even geekier than it sounds…running “a basket of strategies” on 19 different commodity futures, exposing its clients 51% to energy, and going both long/short yet again…

In short, “Burned Subprime Investors Eye Commodities for Growth,” as Reuters puts it. The impact on your cost of living should prove as dramatic as the bubble in global real estate they’re now fleeing.

But the urgency of this autumn’s switch into commodities — driven by the flight from property and paper — is something else entirely. The Ph.D.s who cooked up the U.S. housing bubble are now applying their haute finance skills to gearing up the cost of natural resources.

Hence the complexity of the very latest commodity offerings. Expect a side order of inflation to reach your dining table as a result very soon.

“The reality is that there are still few options for investors interested in gaining access to commodities through a fund,” says John Fearon, director of Oceanic in Sydney. “The thirst for some exposure to commodities markets is growing all the time.”

This sudden thirst for — and eager slaking of — schnapps-style commodity products begins, naturally enough, with the threat of inflation. Crude oil has more than quadrupled in barely five years. Wheat prices have doubled since April of this year. Gold, that speechless seer of price inflation ahead, has shot 15% higher in the last eight weeks alone.

That bodes ill for the value of cash in the bank and pay packet.

“Other commodities are major industry inputs, [so] their relative prices change with the business cycle,” found David Ranson of H.C. Wainwright & Co. in a study for the World Gold Council of November 2005. “Gold is not subject to these distortions since it is not a major input to industry. Changes in the gold price are thus a good barometer of changes in currency values — and ultimately in the absolute level of prices.”

Comparing gold with oil, for instance, between 1951-2005, Ranson found that gold’s correlation with the producer price index one year later was 0.37. Crude, on the other hand, managed a mere 0.01.

For consumer price inflation 12 months hence, moves in the gold price averaged a 0.50 correlation, more than twice the correlation between oil and the CPI.

The current move in gold, leaping above $750 per ounce this month, was kick-started by the world’s biggest central bank — the U.S. Fed — cutting the price of dollars borrowed by the world’s biggest commercial banks. The Fed cut its “discount” rate by 0.5% on Aug. 17, back when gold was trading nearly $100 per ounce below current prices.

When unlimited money supply growth crashes into rising demand for limited-supply essentials — such as natural gas, copper, soybeans, and cocoa — the result is sure to be price inflation as violent as the monetary inflation that preceded it.

Add a sudden wall of money from Wall Street, the City, Frankfurt, Paris, and Tokyo…all seeking a growth market to replace the can’t-lose gamble of home loan trading and credit…and the surge in basic resource prices will only accelerate.

Now add a little pixie dust…plus a dollop of leverage…and voila! One ’70s-style inflation — or worse — cooked to order.

“There has been hedge fund interest” in cobalt, for instance, says Nick French — a cobalt dealer at SFP Metals in London — but not because the hedge funds foresee rising demand for hip replacements, loudspeaker magnets, jet turbine engines, or other of the metal’s major end uses.

Instead, “If you can push the price of cobalt up to $40 per pound from $20,” says French, “then the share price of a cobalt mining company will double.” Credit Suisse now offers a cobalt contract settled in cash, but backed by physical metal. But futures contracts, based — like everything else offered to investors by the high finance industry — on credit, are only the start of it.

“An army of structured credit experts is studying products such as collateralized commodity obligations, or CCOs,” reports Reuters, “tied to the performance of a portfolio of underlying commodities, such as precious metals or energy prices. In a CCO:

“The issuer sells protection on the underlying commodity portfolio to the swap counterparty under what is known as a ‘trigger swap agreement.’

“To fund its obligations under the swap, the issuer sells notes in the amount of the protection sold, according to Fitch [Ratings]. Proceeds from the notes then serve as collateral for the issuer’s exposure under the swap until it matures.

“At maturity, the issuer liquidates the remaining asset and returns the proceeds to noteholders.”

With it so far? My guess is — and at least I’ll confess it’s just guesswork — that the Reuters journalist and most likely the bulk of investors about to start buying CCOs have no idea quite what these products are, either. All they’ll see, instead, is a steady stream of potential income. Provided, of course, that the CCOs pay out at maturity.

Barclays Capital created the first CCO to be approved by the global ratings agencies back in 2004; in April of this year, Credit Suisse issued $190 million in “triple-A” rated CCO debt, denominated in U.S. dollars, euros, and the Aussie.

“This product has opened up a new investment opportunity for investors who traditionally have not had exposure in commodities as an asset class,” reckons Bikram Chaudhury of Credit Suisse’s fixed-income desk.

In other words, bond managers and fixed-income traders whacked by the collapse of mortgage-backed debt can now put commodities into their portfolios — and just in time, too, for the runaway inflation about to hit thanks to monetary oversupply and heavily geared financial buying. The magic of finance has turned consumable lumps of natural resources into a stream of income…without the bother of digging the earth or planting a crop.

But don’t feel left out! The global finance industry is more than willing to help you gear up, too. Morningstar, for example — the U.S. mutual fund rating service — just launched a series of commodity indexes applying basic momentum theory to go long or short when prices break the 12-month average.

“It cannot be long before exchange-traded securities will allow retail investors to take part in the action,” says John Authers in the Financial Times.

Macquarie Bank in Australia, meanwhile, is now advising you delay making any commodity stock purchases…lend your money to them on a “Hi-Note” instead for 30, 90, or 180 days…earn a “high yield” in the meantime…but nominate now the purchase price you’ll pay — of between 85-100% of the current share value — when the note matures.

High income, eh, with a cut-price mining-stock future thrown in for free? Sounds too good to be true, don’t you think?

It may be worth recalling that when Refco, the U.S. commodities and derivatives brokerage, went bust in late 2005, Jim Rogers’ Raw Material Fund was owed more than $362 million, according to court filings.

I’m not saying that any of the banks or brokerages now brainstorming clever new ways to gear up commodity profits is acting fraudulently or illegally today. Refco, on the other hand, was accused by Rogers of seeking to “brazenly violate the funds’ instructions and deceitfully divert the funds’ assets to an insolvent, unregulated entity.”
But making the right call in commodities — and betting they’re only set to rise from here — won’t guarantee you turn a profit. Not if you rely on somebody else making the trades or making good on a credit-based promise.

Simply buy and sell the physical asset yourself, and at least any profits you make — and losses you suffer — will be yours to regret alone.

Adrian Ash

October 31, 2007

The Daily Reckoning