The following editorial was published in Price Perceptions issue #1101 on July 12, 1997

Feast to Famine… and Back Again!

Last year, supply/demand conditions in grains were historically tight and prices reached record levels. This year, conditions have eased, but prices have plunged to three year lows... Have we returned to chronic surpluses? Did last year’s high prices destroy the demand base? Were price levels of the past two years an aberration?

Many in the grain trade are asking these questions following the price plunge of the past four months. However, grains are not the only markets that plummeted... crude oil fell 32% since December... coffee prices declined 42% from late May... copper plunged 16% in the past three weeks... and gold dropped to twelve year lows this week. The CRB index, a widely accepted measure of commodity inflation, declined 9% in value over the past six weeks. What's happening? Are we headed for price deflation? Has global economic expansion ended?

To answer these questions, we must look to the most rudimentary elements of economics - money flow and government programs...

During the Sixties, the Federal Reserve expanded money supply to pay for the Vietnam war. The unprecedented liquidity expansion forced the US to drop the gold standard in the early Seventies and the dollar plunged in value. Nobody wanted to hold dollars as they were a depreciating asset. Therefore, money began to flow into markets that held promise of appreciation. Commodities became the first object of monetary speculation. Commodity prices were cheap throughout the Sixties and production failed to keep pace with world economic expansion. As more and more money flowed into commodity markets, prices rose and food became the object of monetary speculation. By the mid-Seventies, monetary speculation turned toward energy and oil prices spiraled to record levels. Following energy, real estate and precious metals attracted the bulk of monetary flow and became the favorite inflation hedge of the late Seventies.

By the early Eighties, consumer prices were spiraling and the Federal Reserve decided to end monetary speculation in commodities and real estate. They pushed interest rates to record levels and money began to flow toward interest bearing securities. The dollar rose sharply as foreign capital was attracted to record returns in US treasuries. However, the flow of money to interest bearing assets slowed the world economy and the Fed became fearful of a depression. They quickly reversed course and began pumping money back into the economy.

Money supply expanded sharply after 1982 and interest rates fell. Investors were no longer attracted to interest bearing assets and began to look for greener pastures. Commodities were not attractive as producers had responded to record prices by expanding production. In addition, President Carter halted commodity sales to Russia and grain surpluses reached record levels. Precious metals were no longer an attractive investment as foreign central banks learned they could earn interest by holding reserves in US treasuries rather than gold. With few alternative choices, money began to flow into stocks. As the stock market became the focus of monetary flow, stocks rose to record heights by 1987.

Alan Greenspan, the newly appointed head of the Federal Reserve, vowed to push inflation to zero. In 1987, he engineered a series of small interest rate hikes in an effort to squeeze inflation out of the economy. However, the ploy backfired and the object of monetary flow... the stock market, fell instead. The Fed quickly changed course and interest rates have remained relatively low since that time. As a result, money has continued to flow into world stock markets, driving prices to record heights.

The unprecedented flow of money into securities promoted the greatest global economic expansion in history. Economic growth, has in turn, increased demand for raw materials and commodities. However, commodity prices have been held in check by...

  • World Trade Agreements: Many nations have reduced, or eliminated, trade barriers. As a result, when supplies become tight in one hemisphere, they are imported from another hemisphere. This has allowed world commodity reserves to decline with little fear of shortages or high prices.

  • On-Time Inventory Management: Commodity users have learned to reduce costs by minimizing investment in inventory. In addition, they realize when supplies run tight, prices do not remain high for long. Therefore, it has become conventional wisdom to risk higher prices for short durations rather than buy ahead to cover future needs. This has pushed the burden of inventory ownership back to the farmer. However, the farmer is also learning to pare inventory as grain left over at the end of the season falls sharply in value.

  • Freedom To Farm: For the first time since passage of “New Deal” legislation in 1934, there is no safety net below US grain prices. Although a nine month loan program is still available to assist farmers in storing crops after harvest, loans cannot be rolled forward into the reserve as in past years. Therefore, farmers must sell their crops during the current market year or finance the inventory without price protection following loan maturity. This has forced farmers to sweep bins clean before the end of the crop year. It has also made supply levels at the end of the crop year a more critical market force... If supplies are large, prices can fall below loan due to marketing loan aspects of the program... If farmers misjudge demand and sell too much before the crop year ends, supplies can become extremely tight for a short period of time. This can result in a brief, upward price spiral that rations demand to available supply.
Because government programs are designed to clear inventories each year and encourage imports to meet spot shortages, the marketplace has adopted the attitude that...

“Any temporary price advance will be quickly
arrested by greater production and/or imports.”

However, world liquidity continues to grow, building a greater demand base for raw materials and commodities. Excess liquidity is searching harder than ever for new profit opportunities and could begin flowing toward commodities at any time.

The opposing directions of these two forces (money flow and government programs) have caused highly volatile markets. While this has led to a great deal of confusion and frustration for those trading commodities, it also provides much greater opportunity. We must become accustomed to market overreaction and learn to use it to our advantage. Because more and more liquidity is flowing into commodity funds, prices are driven higher and lower than justified by old measures. Fundamental forces still dictate market direction... But, price extremes are exaggerated by growing commodity fund liquidity and uncertainty generated by free trade policies and lack of government safety nets.

We can no longer use traditional yardsticks to measure short term value. Markets can be expected to move from feast to famine and back again many times over the course of a marketing year. Adjusting to the new environment by reducing position size during latter stages of major moves should enhance profitability in the future.

Bill Gary
CIS, Inc.


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