For the past five years, the Reuters CRB index closely tracked the up-trend in global stock markets. The Morgan Stanley Composite All-Country World Index reached a six-year high of 1407 on August 11th, up 90% from its lows in October 2002, led by spectacular gains in Brazil, China, India, Korea, and Russia. On the same day, the Reuters CRB index reached a 25-year high of 365.45. Both asset classes were energized by the global economy's 5.1% annualized growth rate in Q'2 2006, its best performance in 30-years.

At its peak frenzy, traders figured that worldwide demand would soon outstrip the worldwide supply for key industrial commodities, such as crude oil, copper, iron ore, nickel, and zinc. Over the past five years, Chinese demand for steel has grown by around 19% a year, for aluminum and copper it rose 16%, and imports of zinc soared to a record high of 860,000 tons in 2005. China will consume 7.4 million barrels of oil a day in 2006, an increase of nearly half a million from a year earlier, representing 38% of the total growth of the world's oil demand.

In India, the world's second most populated country, the economy is expanding an annualized 8.4%, the fastest after China, and its industrial production was 12.4% higher in July from a year earlier, the fastest pace in a decade. Prime Minister Manmohan Singh aims to boost growth in the $775 billion economy to 10% a year in the next decade, from an average 8% the past three years. The Indian Oil, the nation's biggest refiner, is boosting crude oil imports 14% this fiscal year, and is spending $20 billion to boost its refining capacity by 2010.

So what major outside forces knocked the "Commodity Super Cycle" off its upward course, and then led to the latest plunge in the Reuters CRB index? According to the charts above, the CRB moved drastically out of alignment with the global stock markets! The CRB index is 16% off its 25-year highs, with the king-pin crude oil and gold markets 20% lower, the copper and zinc markets are off 17% to 19%, yet the global stock markets were left unscathed.

Is the latest down-turn in the industrial commodities signaling the onset of a global economic recession, led by a US housing slump or a hard landing in China, and not yet reflected in the global stock markets? Or did the rout in the Reuters Commodity index simply wipe out a swath of speculative froth after a four-year climb, a classic shake-out of over-extended long positions, and presenting bargain hunters with new opportunities to make money in a longer-term secular bull market?

The major forces that have rattled the Reuters CRB index within such a short period of time, to its lowest level in a year and a half include, (1) Global central bankers are lifting interest rates in unison, and slowly draining global liquidity. (2) Beijing is tightening its grip on the yuan money supply, leading to exaggerated fears of a hard landing for China's economy. (3) Crude oil traders unwound a $15 per barrel Iranian "war premium" after Europe's big-3 signaled a split from the Bush administration's campaign for UN economic sanctions against Iran. (4) Weaker crude oil prices triggered a rout in the gold and silver markets.

Central Bankers Unite in Battle against the "Commodity Super Cycle"

Coincidentally, the peak in the historic CRB index rally was recorded just three days after a May 8th meeting of central bankers from leading industrialized and developing countries in Basel, Switzerland. Jean-Claude Trichet, spokesman for the G-10 group of central bankers, urged members to avoid complacency, because inflationary expectations were rising during a period of high commodity and energy prices.

"It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation. Global economic growth remains strong and steady, but there are elements there that call for very special attention, especially in terms of inflationary risks. We have to look at the inflationary risks with great attention," Trichet declared.

Central bankers from a dozen different countries heeded Trichet's siren call to tighten their money spigots, including emerging market giants in China, India, and Russia. A barrage of quarter-point rate hikes by a united front of central banks, and higher bank reserves requirements in China and Russia, started to flatten out the Reuters CRB index in June - July, and then greased the skids for its biggest downfall in 16-years, in August and early September, led by a $15 /barrel slide in crude oil.

The Federal Reserve finds the "Neutral Rate"

The Fed tracked the Reuters CRB index with a string of 17 consecutive rate hikes to 5.25%, but with central banks in Asia and Europe pursuing ultra-easy money policies, the job of getting ahead of the commodity inflation curve was much tougher. Once central banks in China, the Euro-zone, Japan, and India joined in the tightening campaign in 2006, the Fed's job was done.

But in the aftermath of the severe collapse of the CRB index below its key upward sloping trend-line, it doesn't take an expensive college education to figure that after a few more months of a steady hand, the Fed's next shift would probably be towards lower interest rates. US housing stocks rose by 10% last week, despite grim news on new and existing home sales, on expectations of easier money in 2007.

European Central Bank Brings Up the Rear Guard

On July 19th, Trichet signaled a new policy that takes commodity prices into account when deciding on Euro zone interest rates. "High oil and commodity prices demand close attention, and should not be ignored when measuring true inflation levels in the Euro zone," Trichet argued. "The phenomenon is very important and we have to understand it. We are in some kind of supply shock but also a demand shock with the emergence of new giants. It calls for great attention on our part," he added.

The ECB left its main rate unchanged at 3% last week, but left little doubt that it planned to hike rates for a fifth time in October. European politicians worry that too much credit tightening could snuff out the best Euro-zone growth in six years, just as the region has emerged out of a long slumber. But ECB members Errki Liikanen of Finland and Yves Mersch of Luxembourg said that the ECB's focus must remain firmly on tackling inflationary pressures.

"We need to guarantee that inflationary expectations will be solidly anchored, and that is why we also need to act. If the current economic scenario is confirmed, we need to continue the withdrawal of monetary accommodation," said Liikanen. The ECB "will exercise the greatest vigilance, not just in the immediate future, but you should also expect that the ECB won't have lost its imagination at the end of the year. We would not quarrel with the markets, as they see the present and immediate next steps of the ECB," Mersch added.

The ECB was very late to join the inflation fight, and waited until the Reuters CRB index had eclipsed the 320-mark, before lifting its repo rate from a 50-year low of 2.00% to 2.25% in December 2005. Now with the Fed and the BoJ sidelined, the ECB becomes the hatchet-man to combat the "Commodity Super Cycle" with a few more residual rate hikes in the months ahead. Futures markets in Frankfurt project three more ECB rate hikes to 3.75% by March 2007.

Bank of Japan's heavy hand

On March 9th, the BOJ signaled the end of its radical monetary policy called "quantitative easing" and moved quickly to drain liquidity out of the Tokyo money markets. By the time the Reuters CRB Index had reached its peak on May 11th, the BOJ had already withdrawn 16 trillion yen from local banks. By the end of August, Japan's monetary base, money in circulation plus bank deposits, had fallen by 26.5 trillion yen since March 9th, leading to further unwinding of the yen carry trade.

The Chinese Wildcard, is a hard landing on the horizon?

China's economy requires 7% growth to breakeven with the number of new workers entering the job market each year. China has been riding a boom in exports and fixed-asset investment for the past four years, and repeatedly defied expectations of a slowdown. However, the juggernaut Chinese economy could slow to single digit growth, if the People's Bank of China (PBoC) tightening steps begin to bite, and the huge trade surplus dips in response to slowing US growth.

On Sept 10th, PBoC chief Zhou Xiaochuan said the 11.3% annual growth was "a little bit too high, and there are several macro-economic adjustments to slow it down a bit. Liquidity is still abundant in the Chinese economy so we are going to squeeze the liquidity. There are several ways, we can either expand the operation on open markets, we could once again use reserve requirements, it's flexible," he sad.

"China's priority for the rest of the year is to rein in capital spending and it will rely more on monetary policy measures, rather than administrative curbs, to do so," warned Vice Premier Zeng Peiyan on the same day as Zhou. "The priority for the second half is to control the over-rapid increase in fixed-asset investment. We will try to rely less on administrative measures and mainly use economic and legal measures in our macro controls," Zeng declared.

"That includes appropriately adjusting money supply and credit and taking comprehensive measures to mop up liquidity in the banking system. We will also improve the formation mechanism of the yuan's exchange rate." Two days later, the People's Bank of China backed up its tough talk with action by mopping up a record 225 billion yuan ($28.3 billion) in its open market operations on Sept 12th. That was nearly double the 120 yuan withdrawn from banks by the PBoC on July 12th.

Further restrictive measures are expected and the big question is whether Beijing will tighten too far and push its economy into single digit growth. In the event that the PBoC tips the economy towards 7-8% growth, as the latest downturn in commodity markets and Australian mining shares suggest, the tremors would ripple through-out Asia. A sharp slowdown in the US economy, linked to a downturn in the housing market, is also a risk to China's economy, where exports amounted to 40% of its GDP, compared with about 25% in France and 10% for Japan.

In August, Chinese imports jumped to a record $72 billion, a stunning 24.6% higher from a year earlier. Therefore, any sharp slowdown in the Chinese economy would also be felt by neighboring exporters in Australia, Japan, and South Korea, whose sales to China are at all-time record highs. Already, Korean exports to China, which grew in excess of 50% during 2004 and into 2005, have slowed to a pace of 12% in the first half of 2006. China accounts for more than 20% of Korea's foreign sales.

On Sept 18th, Qiu Xiaohua, commissioner of the Chinese National Bureau of Statistics, said Beijing should aim to lower its annual economic growth to between 7% and 8% to keep output on a sustainable path. "Judging from constraints upon capital and energy supplies, an average annual GDP growth rate of 7-8% is manageable, but a growth rate of 9% is not," he concluded.

"Growth of 9% would create massive oil supply shortages and lead to such rapid expansion in investment that it would warp the economic structure and make it difficult to sustain growth. Annual growth of anything beyond 9% would probably lead to an inflation rate of greater than 5%," Xiaohua said.

Australian Miners Rattled by fears of Chinese Slowdown

Exaggerated fears of a hard landing for the Chinese economy were evident in mining giants BHP Billiton and Rio Tinto last week. Australia's BHP Billiton, the world's biggest mining company, posted a 77% increase in second- half profit, to $6.1 billion on August 23rd. Sales to China jumped 50% to $3.6 billion in the second-half from a year ago. Yet BHP shares have tumbled by 10% since reporting its stellar earnings.

Rio Tinto, the world's second-largest mining firm, posted a better-than-expected 80% leap in first-half profit on strong demand for minerals world-wide. Half-year underlying net profit rose to $3.75 billion from $2.09 billion a year earlier, China accounted for 14% of the company's $10.6 billion in sales. Copper made the single biggest contribution to Rio's bottom line, generating $2.79 billion in earnings before EBITDA, followed by iron ore, which accounted for $1.66 billion. Yet Rio Tinto shares are 12% lower since reporting its stellar results, on uncertainty over China.

Australia's Zinifex Mining, ZFX.AX, the world's second largest zinc miner, topped out on May 12th at A$13.54 /share, after the PBoC and G-10 central bankers kicked off their mini tightening campaign. China is the world's biggest consumer of zinc at 3.08 million tons in 2005. On August 24th, Zinifex said its fiscal 2006 profit soared to A$1.08 billion from A$231.6 million a year earlier, and paid a final dividend of 70 cents a share, up from 4 cents a share a year ago.

Zinc tripled to a record high of $4,000 per ton on May 11th, but has since settled around $3,230 per ton, off 19.2% from its all-time high. Every 1% change in the zinc price is worth about A$14 million to Zinifex's bottom line. "If zinc prices over the course of 2006/07 continue at similar levels, then increased revenue will more than offset expected cost escalation and we would anticipate another excellent year for Zinifex," the company said. However, Zinc will be a very tough nut to crack, with London stockpiles dwindling to 155,000 tons, or 75% lower since June 2005.

Unwinding the $15 per barrel Iranian 'War premium"

The most influential driver behind the CRB's plunge since August 8th however, was the unwinding of the Iranian "war premium" which had inflated the price of crude oil by as much as $15 per barrel this year. Iranian negotiators have skillfully split the British, French and the German coalition away from the Bush administration's hard-line stance for economic sanctions against Iran.

Iran's rulers have always relied on the Russian and Chinese veto to any economic sanctions, but now there are signs the Europeans are also seeking a way out, once the moment of truth had finally arrived. On Sept 13th, British Foreign office minister Kim Howells waved the white flag, "I can't see a military way through this, and I'm not sure that even there's an easy way for the UN to impose sanctions," he told parliament's Foreign Affairs Committee.

Economic sanctions against Iran would jeopardize more than 10,000 jobs, the German Chamber of Commerce said on Sept 1st. "Economic sanctions against Iran would solve none of the political problems. But the German economy would be hard hit in an important growing market." France's oil giant Total is interested in a 10-15% stake in Iran's Azadegan, seen as one of the largest unexploited oilfields in the world, said head of exploration Christophe de Margerie on Sept 12th.

On Sept 18th, French President Jacques Chirac formally abandoned his partnership with the Bush team over Iran, "I am never in favor of sanctions. I have never observed that sanctions were very effective," he told Europe1 Radio. Earlier in the day, Norwegian energy and aluminum giant Norsk Hydro, signed an oil exploration deal with the National Iranian Oil Company for the Khorramabad block.

Iran's chief nuclear negotiator Ali Larijani reportedly offered a 2-month suspension of Tehran's nuclear enrichment program in talks with EU foreign policy chief Javier Solana, which sent crude oil plunging below $66 per barrel. Still, there are questions of whether or not Iran's internal debate is over, and if the concession by Larijani is fully backed by the Ayatollah Khameinei and president Amadinejad in Tehran.

Without the imposition of UN sanctions or the threat of military action against Iran, crude oil succumbed to the laws of supply and demand. US stockpiles of crude oil were 327.7 million barrels last week, or 18% higher from two years ago, when crude oil was trading at $45 per barrel. Unleaded gasoline prices tumbled 65 cents a gallon since August 1st, and boosted US President George Bush's approval ratings by 3% to 41% last week, with seven weeks left before mid-term US elections in Congress.

Some oil traders view the Bush team as a paper tiger in dealing with Iran. Other oil traders think the Bush gloves will come off after the US Congressional elections on November 7th, when whispers of a US military adventure could grow louder. In any case, China's crude oil imports rebounded 15% to 11.8 million tons in August, which could put a floor under the market in the low $60's per barrel range.

Gold Tumbles Under $600 per Ounce

Gold tumbled under $600 per ounce last week, in line with a weaker crude oil and CRB index, telegraphing lower headline inflation in G-7 oil importing countries in the months ahead. Gold has also been pressured by fears of by European central bank sales ahead of a Sept 26th fiscal year-end that limits sales to 500 tons per year. So far, European central banks have only sold an estimated 340 to 360 tons this year.

With central bankers coordinating their tightening moves, there has been little volatility in the foreign exchange markets to influence the price of gold. Instead, gold traders are focusing on crude oil and other key industrial commodities for clues about the future direction of inflation. Supporting the gold market however, is speculation of eventual Chinese central bank diversification into gold. Only 1% of China's $954 billion of foreign currency reserves are held in the yellow metal.

The US current account, the broadest measure of trade with the rest of the world, includes both trade in goods and investment flows, widened in the second quarter to $218.4 billion, and remains a major risk for the global economy. The US deficit totaled 6.6% of gross domestic output, the same as in the first quarter. That compares with China's current account surplus of 7% of GDP.

With pressure mounting on Beijing to revalue the renminbi upwards, China could quietly build a gold position in a declining market. Fan Gang, a member of China's central bank monetary policy committee said on August 29th, "The US dollar is no longer a stable anchor in the global financial system, nor is it likely to become one, therefore it is time to look for alternatives."

19 September 2006

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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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