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QE2 and the Commodities That Cause Riots


Commodity markets reacted so strongly to QE2 because a number of global weather problems reduced harvest forecasts and, with global food stockpiles already tight, grain prices had a running start before QE2 even started.

The problem with macro economics in general, and with QE2 specifically, is that it's impossible to run an experiment on the economy to see how the markets will react until you actually run the experiment in enough size to affect the markets. QE2 was supposed to drive mortgage rates down, forcing money into the stock market, increase the wealth effect, and help small businesses. In effect, create "good inflation," higher stocks, and higher home prices. It sure looked good on paper, didn't it, Ben?

Unfortunately, what all the brilliant academic economists at the Fed failed to model is that a portion of the cash that was supposed to go into the stock market ended up in commodities.

QE2 did not deliver "good inflation," it delivered "bad inflation," which is pretty easy to define -- higher mortgage rates, higher gasoline and heating oil prices, and higher food costs across the board. By any reasonable measure, QE2 is a complete failure with respect to its original objectives, but the Fed is now like the bus driver in the movie Speed. If the Fed comes out and says QE2 will be phased out early because it's not working, the stock market and commodities will crash. Just wait for the Congressional hearings on why the Fed should be allowed to conduct such ill-advised experiments with the American economy. So the Fed has no choice, pedal to the metal, QE2 has to be completed to save face.

Excluding the run up in precious metals, why did the commodity markets react so strongly to QE2? Before Bernanke hinted at QE2 in August 2010, a number of global weather problems reduced harvest forecasts and, with global food stockpiles tight already, grain prices had a running start into QE2.

At the simplest level there are two type of commodities: those for which people will riot and those that they will not. I'm no PhD in economics, but I doubt that higher prices in gold and silver will bring the masses out onto the streets. How about higher prices in wheat, soybeans, rice, and corn? Now we're talking serious riot potential. QE2 was supposed to stop the risk of deflation. Is there any deflation risk in the riot commodities? Here are a couple of examples. Soybean and corn one-year charts are below:

Click to enlarge

Click to enlarge
(Charts courtesy of

What's just as important as the rising prices is the chart underneath. This is the Commitment of Traders (COT) report that actually lets you know who actually has a position in the commodity. Look at the increase in large traders since last July. As a comparison, look at the gold chart. The COT report shows minimal changes.

Click to enlarge
(Chart courtesy of

It's relatively harmless to get a zillion e-mails telling you to put 5% of your assets into gold or silver and it's the same when a guest on CNBC touts the same thing, but if the guest also says you should put 2% of your assets into corn or wheat and here are the ETFs to do it, that has some serious implications. The futures markets for agricultural products were designed to allow farmers to lock in a selling price for their production, food processors to lock in a buying price, and floor traders to hose small retail speculators. It was win-win-win for everyone in Chicago in the good old days.

There has never been what I will call "long-term speculators" in the food commodities until the start of these ETFs designed to continually hold long positions regardless of price. The futures regulators are starting to notice this, and last week the Commodity Futures Trading Commission (CFTC) proposed limiting the number of commodity futures and option contracts that any investor can hold to curb speculation and potential manipulation.

What is developing is that one part of the US government is forcing a policy and another agency is trying to diffuse that effect. Is this a case of the "irresistible force" (the Fed) against the "immovable object" (the CFTC)? I wish it were so, but I think the Fed will just roll over the CFTC. As the riot commodities continue their upward momentum (corn broke out to the upside last week), commodity ETFs -- like PowerShares DB Agriculture Fund (DBA) -- will continue to attract more retail investors, resulting in the purchase of more food futures contracts that will be held indefinitely. Add in hedge fund buying, and let the rioting continue worldwide.

So far, there have been four food riots (Algeria, Morocco, Yemen, and Jordan), and one potential government fall (Tunisia) that could be attributed to QE2. My question to all those academic economists at the Fed: Who'da Thunk? Talk about unintended consequences.

Since the world is going to the dogs, what kind of dogs are Bernanke and the Fed? Lying or Unlucky?

Let's review the lying case. The hidden agenda of QE2 was to weaken the dollar, but that couldn't be mentioned at the start of QE2. Bragging about the stock market up last week, while ignoring "bad inflation," builds a good case for a lying dog.

Unlucky dog? The only legitimate bad luck was that the dollar didn't weaken because the PIIGS in Europe started to fail at the same time QE2 got going. I guess that was bad luck.

I don't think either one describes it as best as naïve does. (I couldn't find a naïve dog joke, dogs are smarter than that.) The Fed seemed to think that all the liquidity generated by QE2 would flow into the equity markets, and none would flow into commodities. Obviously that was wrong.

The riot commodities are going to command a lot of unfavorable attention over the next few months. The pressure will build on the Fed to curtail QE2, so riding the commodity trend has the danger that some morning the Fed announces an "Emily Litella -- Never Mind Moment" and ends QE2, resulting in the first "Black Swan" moment of 2011.

I don't see this happening soon, but at some point some deep out-of-the-money puts may be the best way to protect your portfolio. In the meantime our naïve, unlucky, and deceptive Fed is driving the stock market up. What could possibly go wrong?

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No positions in stocks mentioned.

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