Commodity Rally: Reality or Illusion

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As economists eagerly seek a solid recovery out of tentative green shoots, a collective rally of commodity prices seizes their attention. RJ/CRB, a comprehensive index of commodity prices, has climbed over 20% since its trough on March 18. The benchmark WTI crude oil price has climbed to over 70 dollars per barrel after it bottomed out at only 30 dollars last December.

Is this an evidence of recovery or simply an illusion created by market expectation? Was it merely a brief rebound or a sign of a prolonged rising? In trying to answer these questions, we will look into four determinants of commodity prices: economic fundamentals, dollar value, inflation expectation and liquidity.

Commodity prices tend to move in exaggerated "super-cycles" along with business cycles. The RJ/CRB index usually follows the Gross Domestic Product trends of major economies, especially that of the United States. The upsurge of commodity prices in 2007 was a combined result of the US recovery from the 2006 slowdown and rapid growth in emerging markets such as China. As the US economy slid into a recession in 2008, commodity prices dived accordingly.

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As Europe, the US and Japan saw their GDPs recede to a level from five quarters ago, global commodity prices measured with the CRB index plunged even faster. Now that commodity prices are unlikely to continue dropping with such speed even if the three economies continue to shrink, it is not surprising to see subdued contraction or even a resumed growth in prices. Additional demands have also come from countries that have found commodity prices attractive enough to build up stocks.

Economic fundamentals did provide some ground for the commodity rally. The ISM manufacturing index, a benchmark parameter of US manufacturing activities, rose to 42.8 in May, which is the highest it's been in nine months. In particular, the sub-index of new orders broke through the even level, a sign that the factories will probably return to expansion soon. Exceptional improvements were also reported in housing construction and consumer confidence.

After all, commodity prices are ultimately determined by the strength of the economy. Before a US recovery is officially confirmed, various uncertainties are likely to send prices into a period of fluctuation.

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However, in the short term, market factors can derail commodity prices from the fundamental trend from time to time. As such, the most important factor is the value of the US dollar, which is the currency used to denominate the prices of most commodities. Given the commodities' non-renewable nature, a devaluation of the dollar would certainly lead to inflation in commodity prices, and vice versa.

We have found consistent correlation between the movements of the nominal dollar index and the crude oil price, albeit with a lag of a month or two. For instance, the dollar's devaluation decelerated in January 2008 and a month later, world oil price began to rise at a slower pace, followed by a plunge in the next two months. Since February 2009, the dollar index has gradually lost its upward momentum, and a rebound of commodity prices was later witnessed.

Similarly, US inflation could also lead to rising commodity prices, although the reason is not exactly the same. As investors anticipate future inflation, they quickly turn to the commodity market in hopes of locking in prices at a lower position before they are pushed up by the overall inflation.

Dollar devaluation and US inflation often come hand in hand because they share a common root of excess dollar liquidity. Now that the US Federal Reserve (Fed) has set the target rate at zero and has been aggressively using quantitative easing to pour liquidity into the economy (e.g., purchasing treasury bonds from the marketplace), the risk of the Fed's losing control over liquidity – and the subsequent dollar devaluation and inflation – becomes a reasonable concern. As concerned investors resort to buying commodities to keep the value of their money, the expectation of inflation is self-fulfilled. It could even evolve into stagnation if the economy fails to pick up.

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There have been many instances in history when affluent dollar liquidity has sent commodity prices upwards, although the amount of time for the effect to take place varied. In a relatively sanguine economy, it took no more than half a year for the movement of US base money supply to be reflected in the commodity price index; in a weaker economy, the transmission could be slower. For example, while US base money growth peaked in December 1999 during the 2000 Hi-tech bubble, the CRB index did not top out until February 2002. This is because consumers and producers tend to be more cautious in spending when the economy is in a slump, a condition that also makes it longer for expansionary monetary policies to take effect.

In a bid to stabilize the US economy, the Fed has embarked on an extremely easy monetary policy, illustrated by a multiplication of monetary base into the year-on-year growth of the money supply. Such a rapid growth in US money supply was the first time in two decades, and it is very likely to further elevate commodity prices in the quarters to come.

In sum, we believe the recent rally of commodity prices is partly a correction of overshooting, helped partially by updated economic data, but most importantly, a result from excess liquidity that has weighed on the dollar and brewed expectation for inflation. Whether or not the rally will persist depends on whether central banks will continue the monetary largess or tighten the tap.