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Will High Commodity Prices Last?


Safe haven trades may not stick.

Something I've been thinking about for awhile is the effect investor demand will have on commodities prices. I've wondered about this is because the traditional safe haven trades in these times of uncertainty are't very appealing (think 2% 3-month T-bills). Also, average retail investors have been given the tools (ETF's) to purchase commodities.

So let's think about this now. What happens when investors sell their currency (i.e. dollars) for commodities because they want diversification away from a devaluating currency. The answer is simple, the commodities rise in price and then people/economists get worried about inflation. So now we have investors around the world competing for a fixed amount of commodities. When investors buy a commodity index, they're effectively buying/storing a house full of food (wheat, corn, or soybeans), some barrels of oil, etc.

So where do all these commodities get stored?

Let's go into the world of futures contracts and remember that these are deliverable contracts. What do commodity fund managers do when they get an inflow of investor (safe haven) money? They go out and buy futures contracts, (or derivative contracts based on commodity prices, oh brother more counterparty risk here) usually using the front month contract, which is the closest to delivery.

When the front month contract gets close to delivery, they roll it over (sell the soon-to-expire contract and buy the next front month contract). As a result, the front month contract can have a lot of demand (open interest) that never has any intention of taking delivery because the investors don't physically have the storage tanks.

If you look at various commodities (crude, wheat, soybeans), you'll see the front month contracts are much higher in price than the back-end months. Why so much demand for the front month contracts? Could it be that investors are having a crisis of faith in the paper currencies and are fleeing to real tangible assets while inducing price inflation across the commodity complex?

Won't this just make life more difficult for the U.S. consumer/homeowner as more income gets sucked up in paying for food/energy causing even more problems with loan defaults/delinquencies (think credit cards here)?

But the bigger question I'm pondering is whether or not this price spike in commodities is a temporary spike after the safe haven flow stops. I think so, but I wouldn't want to be the Fed and have to bet on that, especially if it were to lower rates further and pour even more gasoline (Lowering T-bill rates further) on the commodity/safe haven trade.

Interesting times indeed.
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