COMMODITY FUTURES FORECAST WEEKLY REPORT
COMMODITIES GONE WILD!
Philip Gotthelf
(March 30, 2006) With silver rocketing to multi-decade highs and gold roaring forward with platinum and palladium on its heels, the media is awash in "reasons" for the commodity market boom that permeates everything from metals to softs. In glittering generalizations, the press associates the bull market with demand from China and India. Perhaps this is because it is the easiest one-liner, requiring the least explanation. However, there are considerable complexities to current commodity price trends that require more than a reference to China or India. In particular, the potential squeezes in markets like silver, palladium, and platinum moves have less to do with China and more to do with U.S. and European developments.
From the beginning, Fed Chairman Bernanke made his second "debut" before lawmakers to explain his policy and the state of our economy. He offered the perception if "transparency" according to The Wall Street Journal front page today. In keeping with his predecessor, Bernanke suggested that further rate hikes might be required to keep inflation in check. The consensus is that this is a status quo statement that means rates will move to 5% before any policy change is considered. Yet, there is a growing number of analysts that believe Bernanke is likely to moderate rate increases. In particular, a further weakening in real estate represents a trigger for policy change.
It is this limited possibility that has stimulated further interest in commodities. If the world is in the grips of a 1970's style inflation, prices for standard inflation hedges like silver and gold can easily reach and exceed their 1979 all time records. Platinum and palladium have already raised the bar from the "go-go" years of precious metals with palladium reaching $1,075/ounce and platinum touching new records as I write.
Recall that the 1970's inflationary spiral began with agricultural sectors as grains responded to the 1970 corn leaf blight and progressed with the decimation of the Peruvian fish meal (El Nino) and the failure of the Russian winter wheat crop. This spawned the infamous Russian Wheat Deal and subsequent price rockets in wheat, corn, soybeans, and oats.
The grain surge was immediately followed by the oil embargo. In turn, rising energy prices pulled the rest of the economy along for a protracted inflation, stagflation, and a confidence crisis. For those who remember, President Nixon imposed price controls to stem the greenback's deterioration. He was forced to close the U.S. gold window to halt a raid on U.S. supplies. When U.S. gold ownership was legalized in 1975, consumers were already numb from the energy crisis, high foods costs, labor dissatisfaction and unrest, 63¢ sugar, and no end for the dull economy in sight. Coffee inflated after the Brazilian freeze in 1975. In 1976 into 1977, meat prices made new highs and Congress was asked to investigate. The entire wave of commodity inflation culminated Bunker Hunt's plan to return to a metallic monetary system when he attempted to corner the silver market.
The tumultuous 1970's were followed by a decade of adjustment. The 1980's were a response to the 1970's. We saw the creation of financial derivative like Ginnie Mea futures, T-bonds, and T-bills to combat growing price volatility risks. The Fed embarked upon a concerted anti-inflation campaign that took interest rates to the highest levels. Restrictive monetary policy was blamed for the crash of '87. The complexion of financial markets was forever changed as the breadth and scope of participation expanded with explosive growth in retirement accounts and other fiduciary funds. Even individual participation by "the average Joe" altered market behavior and dynamics. The little guy began to count...and still does.
I reiterate this exceptionally condensed history because history repeats. While we have not experienced the same exact sequence of events as in the 1970's, parallels are unmistakable. Absent an oil embargo, we are still seeing breathtaking energy prices. Despite the Fed's attempt to convince us that energy "plays less of a role" in the economy than during the 1970's, reality strikes home every time we fill up at the pump...or pay our newly adjusted electric bills. Indeed, energy is a major part of our personal and corporate budgets. The trickle down has impacted everything from transportation to fertilizer.
El Nino was responsible for exacerbating the food crisis that brought us the Russian wheat deal. By the same measure, hurricanes Katrina and Rita represent Mother Nature's contribution to the growing inflation as demand for goods and services related to rebuilding pressures our economy. Typhoon Larry was a category 5 storm that ripped through Australia's sugar plantations. According to NOAA, the anomalies that brought us last year's devastating storms remains.
Dissimilarities exist because global economic systems have changed. Unlike the stagflation of the 70's, President Bush has worked with regulators, legislators, the Fed, and the Treasury to keep expanding employment. While hardly publicized, U.S. unemployment has actually dipped below the record set by the Clinton Administration currently at 4.8%. Bush's tax relief may be responsible for offsetting an inflation-related backlash. I use the word "may" to avoid raising an argument with readers who are liberally inclined. Democrats insist Bush's relief has only benefited the rich. However, anyone earning $38,000 per year or more has seen the effect of tax relief to some extent.
The reluctance to stall our economy could be the key to Jimmy Roger's prediction for continuing commodity inflation. Of course, Jim has a major incentive to convince everyone commodities are going higher. Higher prices are the basis for his hedge fund investment strategies. He was one of the first to sound the clarion call concerning China's economic growth and potential for driving global inflation. He has emphasized rice as a strategic raw commodity. Given the success of his funds, investors are inclined to take him seriously.
For the most part, participating in the commodity boom can be as simple as buying the CRB or a comparable commodity index and letting it ride. The results have been extraordinary. Take the guesswork out of the process by buying them all! I must confess that my incorrect calls in sugar and copper exemplify the benefits of being a generalist. I should have listened to Jim Rogers and bought sugar. Unfortunately, the technical pattern suggested a consolidation and Larry's damage to Australia's sugar production did not have the immediate impact one might have expected. As mentioned in my previous report, global sugar supplies are ahead of last season and I did not see a magnificent change in consumption that justified sugar's move to new highs. Alas, my perspective does not jive with the consensus!
My redemption comes from my persistence in holding gold long and resuming my long silver position after consecutive bounces. I was bumped out of platinum and, regretfully, failed to re-enter. This is because I was concerned about too much long-side exposure in precious metals. However, timing of the European pollution standard comes while a shortage in platinum continues.
I was speaking with one of my friends in the energy sector who said he expected increasing catalytic contamination as higher sulphur diesel fuels were being permitted to ease the supply crunch. Platinum and palladium do not get along well with sulphur and he said we might see a 5% or even 10% increase in catalytic failures. I am not that much of a detail expert to agree or disagree. However, any additional burden upon platinum supplies would not be welcome.
The Silver ETF
Numerous hype sheets have been circulated extolling silver's virtues as a speculative vehicle. One of the most pronounced and valid arguments favoring silver comes from the recently semi-approved exchange traded fund. This has passed the first hurdle and the chance for a silver stock certificate is one step closer. The Hunt family might get their silver certificates after all!
Implications are vast as I mentioned in previous reports. Like platinum and palladium, silver is an industrial metal that is delicately balanced between supply and demand. Silver's appreciation has been checked by the decline in halide film and the rise in digital imaging. This represents a huge portion of silver demand that is rapidly fading (no pun for film lovers intended). Still, silver is indispensable in electronics, mirroring, and other growing industrial applications.
If the ETF is popular...and I have every reason to believe it will be...silver free stocks will be drawn down by speculation. This is particularly likely with the price over $10 and a continuing bullish outlook for gold and inflation. Can we see silver achieve $20? With enough speculative participation, silver can easily reach $20 and even $30!
Consider the acceleration in momentum. After moving above 104000 resistance, silver's velocity increased with no reference point in sight. Using the measure from 92000 to 104000, we can project to 116000. This goal is only 20¢ away. The next measured objective would be 122000. It will be interesting to watch silver move to these objectives and to identify any stalls that might verify that technical measurements were working.
Unlike the gold ETF that was initially received with a yawn, silver's introduction will come in the beginning of a major bull move. Thus, it is more likely to be received with enthusiasm. If a buying frenzy develops, the trend will be swift and tight. The ETF will be in the cash market and deliveries for futures will dry up.
This is one of the few times investors will have a heads-up on something that could translate into huge profit potentials. In fact, I am considering rolling forward a few deliveries to make sure we can stay in for the long run.
Can The Economy Get In the Way?
There are skeptics out there who believe the flight to quality will be U.S. Treasury bonds and a slowing economy will stop metals like a car hitting a brick wall. They point out that real estate has been a major sustaining force that has turned negative. Any continued tightening by the Fed threatens to halt real estate values and even reverse the trend. Already, housing starts suggest this phenomenon is in play.
Without real estate to support continued borrowing that has sent the U.S. saving rate into the red, there is no support for consumerism. Bloomberg reported that the U.S. economy grew at a 1.7% annual rate in the fourth quarter which is the slowest in three years. In contrast, business spending remained brisk and orders for Boeing jets encouraged investors to keep upbeat. But, if consumers are the economy's driving force, the U.S. economy could easily hiccup. A U.S. hiccup translates into a global spasm. A global spasm can lead to a fast decline in demand for raw commodities. So, there is another side to the story.
One key level to watch will be the 10-year Treasury note. Assuming it inches above 4.76%, housing will probably test new high territory for fixed mortgages. Many economists and real estate professionals believe 6.15% is a critical level for the average 30-year rate because it marks the point where monthly payments represent more than the sustainable percentage of total household income (using average mortgage balances correlated against average household income).
Can the economy get in the way of a bull commodity market? Under most circumstances, yes. For markets where supply is the problem, there will still be long-side opportunities.
March 31, 2006
Philip Gotthelf
Commodity Futures Forecast
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