Commodity Prices, what do they Suggest

Well, I am already on record as paying relatively little attention to commodities, but I do pay attention to prices levels of some commodities, particularly gold, because of what it suggests about the purchasing power of the dollar. The news here is not good. The dollar is hitting 20 month lows against the Euro. Worse, the price of gold has quietly crept up to near $640 and it might go higher.

One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).

Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.

Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.

While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.

I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.

As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.

But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.