The following editorial was published in Price Perceptions issue #1361A on May 24, 2008
Cause or Effect
Congress held hearings this week to discover the reason for accelerating fuel and food inflation. Some blamed oil companies for excessive profits. Some accused OPEC. Others blamed rising food prices on ethanol production. Still others faulted futures markets for excessive speculation. The following examines whether these are the true cause of inflation, or the effect of government policies.
We are all aware index funds have a significant impact on commodity markets. However, testimony this week before the Senate Committee on Homeland Security and Governmental Affairs revealed the extent of their influence. Michael Masters, a hedge fund manager, presented the following points related to the impact of index funds on commodity markets...
• We are experiencing “demand shock” from a new category of commodity speculator, index funds. Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other institutional investors are pouring billions of dollars into commodity futures markets. Collectively, these investors account on average for a larger share of outstanding commodity contracts than any other market participant.
• Index fund assets increased from $13 billion in 2003 to $260 billion as of March 2008. During that time, prices of the 25 commodities composing these indices increased by an average of 183%.
• To illustrate the impact index funds have had on petroleum markets, consider the following. Annual Chinese demand for petroleum increased 920 million barrels over the past five years. In the same period, demand by index funds increased 848 million barrels. The increase in demand from funds is nearly equal to the increase in demand from China.
• Index funds have accumulated the equivalent of 1.1 billion barrels of petroleum, equivalent to eight times as much oil as the US added to the Strategic Petroleum Reserve in the past five years.
• In 2004, the total value of the 25 index commodities was about $180 billion. In that year, index funds poured $25 billion into commodity markets, equivalent to 14% of the total market value of the 25 commodities. During the first 52 trading days of this year, index funds flooded commodity markets with $55 billion, or more than $1 billion per trading day. Demand of this magnitude goes a long way in explaining the extraordinary commodity price increase since the beginning of 2008.
• Traditional policy measures will not work to correct the problem created by index funds, whose allocation decisions are made with little regard for supply and demand fundamentals. If OPEC were to increase oil production, it would have little affect on index fund demand for oil futures. Index fund trading strategies amount to virtual hoarding via the commodity futures markets.
• The CFTC has granted Wall Street banks an exemption from speculative position limits. If a hedge fund wants to buy $500 million of wheat, which is beyond position limits, they can enter into a swap with a Wall Street bank and the bank buys $500 million worth of wheat futures.
Mr. Masters summed up his study of index investors by saying: “You have asked the question, are institutional investors contributing to food and energy inflation? My unequivocal answer is YES.”
In the April 19 issue of Price Perceptions, our editorial was entitled “A New Kind of Protectionism.” We explained that a new kind of trade barrier was spreading rapidly. Not the old kind that kept foreign goods out... But a new type designed to keep goods in.
• India, Vietnam, China, and Egypt recently banned rice exports to hold domestic prices below world values. Because incomes are low in these nations, it is imperative they hold prices down to avoid mass demonstrations and riots. Hoarding of this type only tightens world supplies more, forcing prices even higher.
• China recently placed an untenable export tax on fertilizer to hold domestic prices down. They hope to encourage greater domestic use, which will increase yields. This week, Brazil’s government threatened to nationalize fertilizer production to lower costs to their domestic farmers. Hoarding of fertilizer may increase yields in China and Brazil, but it will limit availability and push prices even higher for nations such as India, Egypt, and others depending on fertilizer imports. This will contribute to even greater food import demand in months ahead.
• This week, the Argentine government limited annual wheat and corn exports to only 500,000 tonnes per company. This was the latest government barrier to curb exports of agricultural goods in order to boost domestic supply and shield their consumers from the effects of soaring world food prices.
Food protectionism is spreading throughout the world. By holding down domestic prices, these nations are discouraging their farmers from expanding production. In addition, it only tightens global availability, driving world prices even higher.
Governments around the world have become addicted to ambitious growth rates. One of the best ways to stimulate growth is to expand money supply and depreciate currency values. Asian nations have long used monetary expansion to pressure their currency and remain competitive in world markets. The world has been on a money printing binge for two decades in an effort to perpetuate growth and avoid recession. Now, it seems as if one nation after another is in a competitive race to expand money and remain competitive in a global economy.
The flood of global money printing has reached a point that inflation is now a global economic problem. In most developing economies, food and fuel are a much higher percentage of income than in the developed world. Therefore, inflation is rising much faster in those nations. However, their governments do not want to raise interest rates because it would lead to a strong currency and reduce competitiveness in world markets. Instead, they are using price controls and subsidies to temper rising prices. This only maintains demand at high levels and discourages expansion of domestic food production.
Cause or Effect
During the Seventies, the US viewed higher oil and food prices as a temporary situation. President Nixon tried price controls, but they only led to greater shortages. He also tried to hold food prices down with export embargoes. That also failed. Now, emerging economies represent a much larger percentage of the world economy. They are attempting to use the same failed policies as the US during the Seventies. The only true way to control inflation is through globally higher interest rates. However, with the global mantra now economic growth at any cost, this alternative is unacceptable to politicians throughout the world. Therefore, the market’s function is to make inflation painful enough to eventually force politicians and central bankers to raise interest rates and slow growth.
This week Senator Lieberman said he was considering legislation that would limit institutional investors (index funds) in US commodity markets. This will only force investors to foreign markets. Argentina’s attempt to control grain and oilseed exports (protectionism) resulted in domestic shortage as farmers refused to market production. As long as the world continues printing money (low interest rates) to maintain ambitious growth rates, one commodity market after another will explode to new heights. It is clear government policies are the cause and continued inflation will be the effect.
TRADING IN COMMODITY FUTURES OR OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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