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Good riddance to the commodities rally
By Tony Crescenzi 5/19/2005
Last week was an important week on the inflation front, as commodity prices continued their recent declines, breaking new ground on the downside. The Federal Reserve has apparently broken the back of commodity inflation by taking actions that have reduced the number of injections of money into the financial system. Adding to this story are recent developments surrounding the outlook for the U.S. budget deficit, which has brightened considerably over the past few months.
The commodity rally thus appears over for now, and although this is bad news for the sellers of commodities, it is good news for the overall economy and the financial markets.
The sell-off in commodity prices has spurred sharp weakness in shares of commodities-based industries such as oil, steel and copper. The decline in these share prices has hurt the overall stock market, as it has lost key leadership.
Nevertheless, this development should be seen as a positive for the long-term health of both the stock market and the economy, as the sell-off in commodity-based stocks points to a more benign inflation picture.
Last week, the Reuters-CRB index, a widely followed index of 17 commodities, fell about 2.2%, reaching its lowest level since February, and the Journal of Commerce index, a key gauge of industrial materials prices, reached its lowest level since last July. The CRB index and the JOC are now down about 9% from their respective recent peaks. Fitting with this is the recent decline in shipping costs, as evidenced by the decline in the Baltic Freight Dry Shipping index, which has fallen from a peak of 6,208 in December to 3,931, only slightly above the 10-month low it posted less than two weeks ago.
U.S. dollar, Fed are key catalysts
The breakdown in commodities can be traced partly to the breakout in the U.S. dollar, which broke through resistance last week to reach a seven-month high.
The dollar rally is rooted in many factors, but owes mostly to the actions of the Federal Reserve, which is reducing the growth in the monetary base and the money supply, two important gauges of financial liquidity. M3, for example, which is one of the Federal Reserve's broadest measures of the money supply and which consists largely of cash, demand deposits, small and large certificates of deposit, and small and large money market mutual funds, among others, has increased at just 4% over the past year compared with 7.4% for all of 2004.
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As I noted several months ago, the monetary base is also growing more slowly. This is important because the monetary base represents the seed money for future money-supply growth, as it consists of so-called "high powered" money -- bank reserves and currency in circulation -- impacted by the actions of the Federal Reserve.
The monetary base is slowing because when the Fed raises interest rates, it does so not by fiat but by adjusting the level of reserves in the banking system.
The slowing in money-supply growth is reducing the growth of money available to buy stocks, commodities, bonds, homes, etc. Whereas there was seemingly plenty of liquidity in 2004 to boost the prices of all of these assets simultaneously, the slowing in liquidity should reduce their buoyancy and this process already appears to be under way.
Mind you, while the reductions in liquidity will likely result in a reduction of spending levels in the economy, the reduction will be mostly in nominal growth rather than real growth, or growth adjusted for inflation. In other words, the slowdown in the growth of the money supply will reduce the inflation rate, hence boosting real growth in the economy. The overall spending level might fall, but more of the spending will go toward increased output rather than toward higher prices. | Market Commentary: Bullish | Commodities' sell-off can be traced partly to the breakout in the U.S. dollar and reduced inflation concerns.
Six months into the fiscal year, the U.S. budget deficit is running $49 billion below the same period a year ago.
The continued flattening of the Treasury yield curve offers further evidence of reduced inflation fears. |
Budget outlook brightens
Also boosting the value of the dollar, and therefore contributing to the recent decline in commodities prices, are recent developments with respect to the U.S. budget situation. Now six months into the fiscal year, the U.S. budget deficit is running $49 billion below the same period a year ago. The deficit, therefore, will likely be below last year's record $412 billion and below the Bush administration's forecast of $427 billion. The nonpartisan Congressional Budget Office recently issued a new forecast for a deficit, putting it at $350 billion.
If the CBO's figure is realized -- and the odds are growing that it will be, the deficit would fall to below 3% of GDP. This would be a significant event, because the 3% mark is widely seen in international circles as an acceptable level for industrialized countries.
In contrast to the U.S., the budget deficits in member countries of the European Union are moving above 3% of GDP due to economic woes as well as changes in rules that regulate the maximum allowable deficits in Europe. In other words, the Europeans will no longer have the U.S. to pick on and will have to look in their own back yard before pointing the finger. All of this is becoming visible to investors, boosting the value of the dollar and hence weakening commodities prices.
TIPS show reduced inflation worry
The bond market has clearly embraced the importance of the recent decline in commodity prices and in the improved picture on the U.S. budget deficit. This is quite apparent in the recent performance of the Treasury's inflation-protected securities. Last week, the inflation rate embedded in 10-year TIPS fell to 2.48% from 2.6% the previous week, and from a peak of about 2.8% at the end of March. Adding to evidence of falling inflation expectations is the continued flattening of the Treasury yield curve, which is now at its flattest point in four years.
While the decline in commodity prices is of major importance on the inflation front, labor cost trends will be even more important, as these costs represent about 70% of the inflation picture. Nevertheless, with the commodity rally snuffed for now, the positive impact that this has had on inflation expectations should not be underestimated, as it will help to keep inflation psychology from moving to the brim.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of "The Strategic Bond Investor." At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy.
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