The Commodities Conundrum

Stocks, bonds, property and commodities have all benefited from the abundance of cheap credit. But will this asset-boom continue forever – or will the party come to an abrupt end? Puru Saxena explores…

Over the past five years, the majority of asset-classes have gone up due to record-low interest rates. Will the boom continue in some assets, whilst the other sectors deflate and correct?

In order to answer the above questions, we first need to examine history. The last commodities bull market peaked in 1980 when inflation fears were widespread and interest-rates were soaring. Throughout the late 70’s, the public exchanged cash for whatever tangible assets they could get their hands on. As a result, commodity prices went through the roof! Gold prices went up over 20 times, oil prices went up from $1.50 per barrel to $40 per barrel, and sugar prices went up 45 times! All this was happening in the 70’s because people lost faith in cash and bought hard tangible assets. During the same period, the U.S. economy was in a recession, Britain had to be bailed out by the International Monetary Fund (IMF) and financial assets were depressed.

It is interesting to note that in 1980-81, U.S. Treasury bonds were being termed as "Certificates of Confiscation"! At the same time, U.S. stocks were selling under 10 times earnings while yielding over six percent! Since the entire world was convinced that cash would continue to lose its value through inflation, nobody was interested in bonds and all the money was going into commodities.

In order to contain these inflation fears and to make cash attractive, the Federal Reserve raised interest rates very aggressively. At the peak in 1981, the Fed Funds rate was as high as 19 percent! Back then, bonds were extremely depressed and (in hindsight) they turned out to be a great investment. Bonds entered a bull-market in 1981 and over the next 24 years, bond investors made a fortune!

Invest in Commodities: The Future of Interest Rates

If you were to look at the Fed Funds rate since 1956, you would see that interest rates soared up until 1981, and since then they have been falling. This trend has obviously provided a boost to financial assets such as stocks and bonds. It is worth noting that interest rates are now close to a record low and may be bottoming out. In fact, I am of the view that in five to 10 years time, interest rates will be significantly higher than where they are today. This will obviously put immense pressure on the bond bull market, which is now over 20 years old!

In the near future, I expect inflationary fears to escalate, as commodities, led by oil, will continue to march forward. To put it simply, I expect tangible assets to, once again, appreciate over the coming years.

At present, the majority of analysts and experts are talking about low inflation and even lower interest rates. The U.S. Treasury market certainly agrees with this consensus view as bond prices continue to rise whilst the yield is extremely depressed. But how do we know that inflation fears will not escalate again? With oil prices hitting record highs and going much higher, how do we know that interest rates will not go up again?

It is my belief that the bond market has, so far, not factored in a significantly higher oil price, which will cause consumer prices to rise in the future. The establishment has done a fine job covering up inflation by manipulating the Consumer Price Index (CPI) in the United States. As far as I am concerned, the CPI figure released by America is a joke – an outright fraud. Despite the fact that every American does spend money on housing and energy, the officials who come up with this amazing concoction called the CPI, do not even include housing and energy costs in their calculations! By keeping "expensive" items out of their index, they continue to fool the world with regards to inflation. So when people hear that the CPI "only" went up by three percent, they feel confident that inflation is under control. This inflation management obviously keeps a lid on interest rates while the bond market continues to hold.

Invest in Commodities: Stocks and Bonds to Deflate

I don’t know about you, but where I shop, prices are heading steadily higher! The price of food has also started increasing gradually. According to the establishment, inflation is around three percent, but how can that be true when prices are rising much faster than that? One day, the public will wake up and smell the rat! When that happens, interest rates will move higher and the bond market may stage a spectacular decline. Under this scenario, stocks will also come under pressure as they usually do when interest rates rise.

So, coming back to our original questions, I expect financial assets such as stocks and bonds to deflate over the coming years. In the short term however, especially if the Federal Reserve starts cutting rates, stocks and bonds may continue to rise. But such a rally may end abruptly once interest rates start rising again.

In the current economic environment, I feel much more comfortable investing in tangible assets. In the 1970’s, commodity prices surged exponentially together with interest rates. Now, commodity prices have turned up again and the universe of tangibles may inflate considerably over the coming years. So far, oil and industrial metal prices have been the biggest beneficiaries whilst precious metals and agricultural commodities have lagged.

Over the coming months, I expect gold and silver to appreciate and at the same time, energy prices may correct. Moreover, agricultural commodities are now the cheapest they have ever been; hence they may surge over the period ahead.


Puru Saxena

September 13, 2005

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Last night, we read about Hitler’s campaign against Leningrad and gave a start. What we had been wondering was why the dollar does not fall; why stocks remain high; and how come people still have faith in the U.S. economy, even though it loses money every day and has no reserves to draw upon?

We believe we can tell where we are in a financial (or even an imperial) cycle by studying the delusions of the participants. In the month of July, for example, the personal savings rate in America went to a negative 0.6%. Not in 70 years had the rate been so low. The last time it was so low was in the Great Depression, when Americans felt their backs to the wall; they had to dip into savings in order to keep going.

Now, they no longer dip into savings. Instead, every emergency sends them running to foreigners, asking for credit. Two nations effectively control the world’s credit: Germany and Japan. Between the two of them, they provide more than half the world’s surplus savings. If they ever decided to stop lending to the United States, the world economy would change quickly.

The cost of Katrina is now thought to go to $120 billion or beyond. Congress has already authorized $62 billion in supplementary spending. But since neither the American government nor its citizens had saved money for this very rainy day on the bayous, they are forced to borrow in order to fix the roof.

What makes the foreigners think they will get their money back? America is already the world’s largest debtor. And it is already effectively insolvent. Add up all the debt and financial obligations of government and private citizens and they exceed the total value of the entire country and everything in it.

Why do they not sell the dollar, rather than buy it? People do not really operate on the basis of hard, rational calculations. Instead, they react to symbols, feelings, delusions and conventions.

In September of 1941, practically all the German high command and every foot soldier in the ranks believed the war was won. It was not a matter of whether or not the Russians would capitulate; but when, how and to whom. They did not seem to notice that they had stretched their lines of supply to the breaking point; that they had no real reserves to call upon; that they were wearing out their tanks and supplies in the opening months of the war; or that they were up against a nation capable of producing more war material than they could, with vastly shorter distances to go to put them into service. The tank factory still operating in Leningrad, for example, built four new tanks every day. They practically rolled out the factory doors and began firing at the enemy.

Instead of thinking hard about the fundamentals of the war facing them; in these palmy days of victory and self-delusion, German officers plotted against their commander-in-chief. They had seen what the S.S. troops were doing to civilians behind the front lines. They had seen, too, what the Nazis had done to Germany’s military, subordinating it to amateurs with a loony political agenda. They saw the Fuhrer as a threat not only to Germany’s battlefield success, but also to the nation’s soul.

"I could have had him arrested," said one of his generals after the war. "It would have been easy." It would have also been the smart thing to d Bring Hitler to justice. Get out of Russia while the getting was good. Make peace with Britain. Live to a ripe old age.

But Hitler was the lawful head of the German state. The army could never quite bring itself to do such a thing. Instead, the generals went along with the program. As a result, most died in combat, before firing squads, or disappeared in Soviet prisons. Germany itself suffered unspeakable horrors…and only recently has been reunified and normalized.

Most people, most of the time, go along with the program, no matter how bizarre and pernicious it is. That is why history runs in such broad currents.

All the world seems to be held together by flimsy webs of convention. You believe you own something, but it is only convention that makes you the owner. That is, it is only so long as others are willing to go along with the program. You might go to your house one night and find another family living there. How would you get them out, except with the aid of a vast network of conventions? You could go to the police, to a lawyer, and eventually to the courts. They might just as well decide that someone else is the real owner; or, as they did in communist countries, that private property cannot exist.

Dictators are said to control their nations by brute force, but what dictator has enough brute force to subdue a whole nation? Instead, he has to rely on an entire web of conventions: An army that willingly supports him, business groups, lenders, religious groups, and workers. Large sections of the population have to go along with the program or it won’t work.

Kings, emperors, and Tsars all depend on the conventions that surround them. Genghis Khan may have ruled one of the world’s largest land empires, but he wouldn’t have ruled even his own tent if his bodyguards turned against him. That is true of business leaders, too. A corporate CEO or a field marshal may give an order, but his underlings could perfectly well ignore it if they wanted to. Factory workers could decide to take the day off. Soldiers could turn on their commanders (and sometimes do) and shoot them. If at any moment people decide to defy convention, the whole jig is up.

Hitler was protected by conventions. It was not customary to arrest the head of state. The campaign against Russia had to run its course to its dismal end. America’s fantasy economy is protected by conventions. And the dollar, too. It was worth something yesterday; people expect it to be worth only a little less tomorrow. It is still the imperial money, the world’s reserve currency. But who bothers to look at the fundamentals? And so, the dollar must run its course, too, to its dismal end.

First, more news from our friends at The Rude Awakening:


Steve Sjuggerud, reporting from Florida…

"The trusty old rule is, whenever a hot investment topic is on the cover of a handful of major magazines, it’s a pretty good signal we’re close to the time to bet against that hot investment."

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening:


Bill Bonner, back in London:

*** The markets still seem trendless, except that gold creeps up. December contracts sold for $453 yesterday. The yellow metal is reaching to a 17-year high. We will keep our buying target at $425 and see if we get another opportunity to buy at that level.

*** Stephen Roach states, "The macro conclusions are inescapable: A saving-short U.S. economy that runs a massive current account deficit is effectively living beyond its means. It not only relies on foreign saving to fund domestic growth, but it also lacks the capacity to invest in public goods that may be needed to safeguard its future. Lacking in domestic saving, the shoestring economy is also biased toward chronic under-investment in infrastructure – leaving itself vulnerable to "breakage." Whether that breakage comes from within (i.e., Katrina) or from the outside (i.e., terrorism), the shoestring economy runs the risk of being unprepared to ward off such blows in a fragile and dangerous world. An energy shock exacerbates the imbalances that produce such vulnerability. This draws into serious question the resilience that financial markets now seem to be banking on."

*** Reports in today’s news say that "blithering idiot" Michael Brown of the Federal Emergency Management Agency has been called back to Washington. He will be replaced by a military man, Thad Allen of the U.S. Coast Guard. It’s a shame about Brown; but the empire needs it heroes and its scapegoats. Maybe he should be posted to Iraq where he could regain his reputation by making daring raids against unlicensed street vendors.

*** All the children are now back in school. The boys began last week. This week, Maria was back in her theatre classes.

We wondered how Edward’s strategy of trying to do poorly on his English exam was paying off.

"I don’t know," he replied. "The trouble is, they put me in a class avec other kids qui sont bi-lingue. So, I can’t goof off too much. But some of les autres parlent anglais worse than me."

"Uh oh…"

We turned to Maria. "How did it go?" we asked at the dinner table.

"Well, everyone was so happy to see each other. They all said they missed each other so much over the summer. Well, to tell you the truth, I didn’t miss any of them. Besides, Anna and Beca visited during the summer. But I was very happy to see them all again. It’s such a different world there. Today, one of our teachers began complaining about New Orleans, and how we Americans never look after our poor people. ‘Well, excuse me,’ I said, ‘but what do you know about New Orleans or how America works?’ They were all against me. They think we’re all racists and fascists and they just seem to want criticize. And then another teacher went on a diatribe about birth control. Well, really, she was talking about abortion. She told us her own stories. I thought she told us too much…more than I wanted to know. And I don’t know what this had to do with acting, but she is so honest about things. She’s really adorable. Still, there are probably some things that are better kept to yourself."

The Daily Reckoning