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Posts Tagged ‘commodities’

Over afternoon snacks today, my father asked me about the bankruptcies of major US banks such as Lehman Brothers, Merrill Lynch, and Bear Sterns, and how that might affect us who lived in Asia. In this modern age of speculative finance, nearly everything you can think of from the food on your table to the prices of gas in your car, to the interest rates on your savings account are all interrelated.

I co-moderate a stock market and finance forum Finance Manila and I recently did a poll of respondents to check how sensitive or indifferent they were to the performance of the US markets the previous night. My poll showed that as much as 2 out of every 3 respondents (and these were mostly Philippine investors and traders) showed some affection for the DOW’s result.

You can check out the details of this poll here.

This level of sensitivity is not surprising, considering that the Philippine stock market has a positive correlation to the performance of the DOW the previous night. In another study I conducted, I found that the general correlation of the PSE Index to the DOW is .30 positive for the last 10 years, and increased to .56 positive in more recent months (since 2007):

You can check out more of the analysis here.

This almost identical movement in both equity markets is simply reflective of the close knit relationships amongst all financial and speculative markets nowdays. The simple reason: the same people investing in stocks here and in the US, are the same people investing in commodities, bonds, and every other securitized asset across the world.

For example, if we track the performance of Oil vs. the US Dollar in the last decade, we see an inverse relationship:

So the movements in various other financial markets is simply the movement of capital from one asset to another. Check out the other relationships here. In a latest CFTC report on Crude Oil, it showed that the level of participation in commodity markets, was heavily biased towards speculators rather than actual producers and manufacturers. This is the reason why, despite many compelling economic arguments for or against the rise in oil, the movement in price has behaved more according to the whim of speculators:

And how do speculators move? Well, that can be based on many factors, but primarily speculative funds move based on two things:

  • Where they can get more profits
  • Where they can avoid losses

And with the recent tumble of equity markes due to the bankruptcies of banks and investment banks, speculators initially sought refuge in commodities, which drove up prices of Gold, Oil, Wheat, and others in order to insulate them from initial losses in subprime mortgages and bank shares. But as the losses increased, speculators were also forced to sell their commodity holdings to help raise cash to pay for their margin calls in other investments.

This means, that even if there is no economic argument of why a bank’s loss can affect the price of fuel–that’s exactly what is happening now.

So going back to my father’s question: does the bankruptcy of Lehman Brothers, Merrill Lynch, and Bear Stearns have anything to do with us, all I can muster is an understatement:

Yup.

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Economies all over the world are presently in the grip of inflationary (even hyperinflationary) environments. This is a direct result of commodity prices that have spiraled beyond conventional notions of supply and demand. Although some will insist that there are fundamental reasons for the rise in Oil, Gold, and other commodity prices, my sense is that it is primarily driven by speculation. For reference, I have written some bits to this note elsewhere.

Arguably commodities are in a “bubble”, the concept of which is not a new term, but it is a controversial one:

http://en.wikipedia.org/wiki/Economic_bubble

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high volumes at prices that are considerably at variance from intrinsic values”. [1][2]

While some economists deny that bubbles occur,[3] the cause of bubbles remains a challenge to those who are convinced that asset prices often deviate strongly from intrinsic values. While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty,[4] speculation,[5] or bounded rationality.[6] Most recently, it has been suggested that bubbles might ultimately be caused by processes of price coordination[7] or emerging social norms.[6]

This present bubble is the result of another one–which is the US Housing Bubble and the bubble in Subprime lending, which burst in 2007, but which surprisingly set off a chain reaction in other financial markets–confounding economists and analysts who reasoned that the crisis in housing and lending were specific problems, and could not possibly affect other markets, let alone affect economies outside of the US.

This apparently is not the case, and I think it is because of one overarching reason: the investors in subprime loans which are collateralized by US housing, are pretty much the same investors in everything else, including commodities which they use as hedges as mentioned above. These large hedge funds and banks, to stem losses from bad loans, turn to buying commodities, which drive them higher–and now leads to inflation.

I came across a roundtable discussion about this featuring some top economic minds and fund managers. Some interesting excerpts:

FORD: One regulatory mechanism is for participants in the system to suffer pain when things go wrong. Have the miscreants suffered enough to act as a deterrent to further misbehaviour?

KALETSKY: Well, the shareholders of Citibank and Bear Stearns have been punished, but they were not the ones who were taking the decisions. The people who made decisions were the directors.

SOROS: Why not shoot them?

KALETSKY: Well I was going to suggest something almost as radical. The idea that for the chairman of Citigroup to be fired with a payoff of a $100m constitutes some kind of punishment is ludicrous. And it is similarly ludicrous to argue that it is a punishment for a trader at Citigroup to be sacked having accumulated $10m, $20m or $30m in bonuses over the last few years.

Check out the discussion here. The causes and effects of this, seemingly endemic and cyclical phenomena in human activity is an interesting critique of human behaviour.

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