The Unthinkable Is The Most Likely Scenario
Heinrich Leopold
As a scientist and engineer working in the commodity industry for over twenty years, it has been always a challenge for me to understand the driving forces for commodity prices. The cycles in this industry have been extreme and influenced profits, projects, careers, but also interest rates as well as currency movements.
Over all these years, the answer to the question what drives commodity price changes from a demand side perspective is: liquidity. It provides the major input for economic growth and thus higher or lower commodity prices. Liquidity is a very broad expression and has many faces. Liquidity is according to my definition 'funds available for spending on goods and services'.
An important source of liquidity on a personal and commercial level are savings in form of cash or funds which are easy and fast to sell. Nevertheless, this is just one part of the whole picture. Liquidity can also exist in form of easy access to credit through a high credit rating or an agreed credit line. Mostly this is correlated with the availability of assets like property or machinery etc..
In addition, liquidity can also change through currency and interest rate movements. Although this is more important on a macro-economic level this can also affect individuals. In Europe many buyers buy property by taking out a loan in Yen or Swiss Franc at low interest rates and converting the money into Euro. If the Yen falls, they reduce their credit cost substantially over time. Over the last five years the yen fell up to 50 % versus the Euro. So there has been a triple advantage: low initial interest rates, falling debt service through even lower interest rates and lower nominal debt in Euro due to a falling Yen. As a summary European property buyers could increase their liquidity substantially through financing their purchase in Yen.
Of course this does not work only for individuals but also for companies, governments and institutions or hedge funds. This process is well known today as carry trade: financing in a weak currency at low interest rates and investing in a strong currency environment at high interest rates. This is important, because this is today in global financing the most important source of liquidity thus very important for commodity prices.
The most important players in this process are Central Banks. They can influence liquidity strongly through simply printing cash ( = M1 money supply) or issuing bonds or buying them back. It is interesting to see that Central Banks have changed their concept of how to provide liquidity to the market over the last decades. In the seventies, it became clear that simply increasing cash does improve economic growth, yet it came at the price of very high inflation.
In above picture there is clearly a correlation between inflation and M1 (=cash) US money supply at a time lag of two to three years. For this reason, another strategy has been introduced beginning of the eighties by the US FED Reserve. Liquidity for economic growth has been provided through increasing M3 money supply.
Through high real interest rates, the US attracted funds from worldwide investors and money savers including worldwide Central Banks. This was the time when the US dollar became the worldwide biggest reserve currency. This strategy has the advantage of increasing economic growth in a low inflationary environment.
Nevertheless as successful this strategy worked over the last decades it has also its drawbacks. Over time the increase of M3 leads to over-indebtedness and leads eventually to a liquidity trap as debt service costs are increasingly a burden for the economy. As the US FED concept of increasing non-inflationary economic growth has been adopted worldwide by nearly all Central Banks in developed countries, Japan got the first victim of this at first sight miraculous strategy. Japan fell into a classic liquidity trap as companies and consumers could not carry the high burden of debt anymore. Inflation, interest rates, property prices and currency fell and stay still in a decade long agony.
Nevertheless, the implications of Japan's deflationary spiral has been very beneficiary for other countries and the worldwide economy. It became a huge source of cheap financing first mainly for the US, but then for the whole world. So, one of the main drivers of the dotcom bubble in the nineties has been Japan as it provided cheap financing for any projects at higher return other than Japan's low yielding government bonds.
The side effect has been nevertheless that - despite initial very high growth - also the US and Europe are sliding slowly into a deflationary spiral. Through this slide into a liquidity trap , Europe and the US themselves are now taking over the role of being a cheap financing source for the rest of the world - mainly China and India. It is exactly the deflationary environment in the US and Europe together with the still Japanese deflation which is providing enormous liquidity to the rest of the World economies. Just like dominos falling into depression, but helping the next country to finance its own credit bubble, Japan started the process, financing the credit bubble in the US and Europe, the US and Europe are financing now a new gigantic debt bubble for China and India as well as Latin America and Eastern Europe.
As developing countries have still to catch up in consumption of raw materials, the consequence for the World economy and commodities are equally huge and absurd: we will have sky high commodity prices over a long time at absurdly low interest rates and inflation.
In my view we will see already during the next weeks the deflationary effect in developed countries as the recent interest hikes will prove to be simply too much for the hugely indebted US and Europe. Inflation will fall steeply and will drive down interest rates accordingly to an unbelievable low rate in a very short time. Nevertheless, this will provide enormous liquidity for the world economy and new demand for raw materials including gold and silver. Record high commodity prices at record low inflation and interest rates: unthinkable, but the most likely scenario over the next decade.
I look forward to receiving your comments.
Heinrich Leopold
hgleopold@yahoo.com
15 September 2006
Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.
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