The *Real* Case for Commodities

This is very true. There is comfort in owning stuff, that as Dennis Gartman says, “would hurt if they were dropped on your foot.”

Oil, gold, corn, wheat—perhaps the most attractive thing about commodities is they seem so concrete. Investors know that a barrel of oil may be worth more or less at the end of the day, but it will never disappear. In an age when major financial institutions can go bust overnight, that holds a lot of appeal.

via The Case for Commodities – BusinessWeek.

But the premise that this is a move to hedge against inflation, in my mind is false. To me, there is something bigger going on here and it’s not just an inflation play.

To start, let’s discuss what these commodities are priced in: dollars.

Since most commodities are priced in U.S. dollars, 2010 may be a good year to invest in them. That’s because the Federal Reserve has kept interest rates close to zero and increased the money supply dramatically, a move some experts say will ultimately devalue the dollar and spark inflation. As the amount a dollar can purchase decreases, commodity prices rise in relative terms. “Inflation usually starts by the government printing too much money,” says Victor Sperandeo, a commodities trader and developer of a commodities index called the S&P Commodity Trends Indicator (S&P CTI). “Never in its history has the U.S. printed more money. When inflation becomes visible, we will start to see stocks slow down and commodities accelerate.”

The dollar is the world’s reserve currency, and it’s a fiat currency. Investopedia defines fiat money this way:

Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith.

The “faith” being spoken of is the faith that the currency is going to be worth something tomorrow. Most people just assume that this means higher prices and a loss of purchasing power. And there has certainly been a lot of that:

But there may be some other forces at work here, and we shouldn’t rule them out. As I mentioned in looking at the credit market, as Hank Paulson’s “repricing of risk” continues, Bill Gross’ “new normal” unfolds. The credit market’s view of the risk/return relationship has undergone a major change. What made sense from a risk/return perspective 3-5 years ago doesn’t make sense now. The volatility in price moves we see is an indicator of just how cautious everyone is: in a world where there’s little risk, people have very little incentive to change their habits and patterns. We left that world behind us sometime in ’07.

And looking at the Fed’s balance sheet, their risk/return perspective has undergone a shift as well:

Where the market’s risk/reward set-up has become more cautious, the Fed has become much less so. But there’s one teeny, tiny, problem:

Part of the Fed’s job is to manage the dollar. In my mind, that should be its only job, but the dual mandate they are under is frankly, asinine. Full employment and price stability? Who comes up with this stuff? Everyone knows the incentive in such a regime is to maximize employment because price stability involves administering discipline. It involves doing something that will make most politicians howl: saying “No.”

The chart shows the Fed has undergone a regime shift in how they manage the central bank, and by proxy, the dollar; the symbol for all fiat currencies. If there was extreme distrust of the Fed and the dollar, the risk wouldn’t be hyperinflation, it would be in going back to a barter system. Think of the benefits of a paper/fiat currency: easy to carry, easily exchanged with other fiat currencies, etc. The purpose of a currency is essentially to facilitate trade. In order for that to happen, you need belief that the paper will be worth something, and someone will protect its value.

But what if nobody believed anyone was willing to stand behind their currency, and protect its value? What do you use? You use commodities and you settle trades with an actual physical settlement, unless you introduce the use of credit and IOUs. But the abuse of credit brought us to this point and the pendulum has swung to being risk averse, so if credit/IOUs were extended, the terms would have to be tight, and physical settlement has to happen pretty quickly after a transaction.

So we don’t need to see hyperinflation or a big spike in inflation to take hold. We just have to be more skeptical, more cynical of our governments and central banks to protect our money’s value.

And that’s a bull market that has really strong, powerful legs to it.

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Filed under finance, macro, Markets, Way Forward

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