The Headless Chickens Rule the Roost

Commodity prices have had a speculative bid for years now helping prop up their prices, especially oil. In the last few months, that bid has ramped up to ridiculous (yes, that is the appropriate word) levels. As mentioned in a previous post, is there any real world justification for the price of wheat to be four times higher than last year or for silver to be three times higher? The middle class of emerging markets, the alleged driver of the current price moves, couldn't possibly be demanding that much of everything simultaneously to cause this kind of move. It isn't often that you get to see a bubble form, so take advantage of the opportunity. Money looking for a home these days (take a look at the money flooding into money markets recently and you can see that there is plenty of liquidity, read the Fed has done its job, floating around. However investors are shying away from risk, hence the buyer's strike in non-commodity markets.) is being attracted to the only way is up market, commodities. The "big" money is playing the futures and the "small" money is playing the futures and ETFs (as a side note, if I had recommended making an ETF that used a single bond, say the 10yr Treasury as its backing, I would have been vilified in the press and brought up on charges by the SEC for ripping off the small investor. In the commodity world , it is OK.). Hedge funds especially love this because of the 100 to 1 leverage (or gearing, for my British friends) available in futures. To quote a popular radio ad, it is the biggest no-brainer on Earth, particularly when you figure the market only moves in one direction.

Here's the problem. The players in the commodity futures market has changed recently, but the structure of the market has not. Originally, these markets were set up by producers and users of the commodities as hedging vehicles. While that still occurs, the vast majority of action happens due to speculative moves by the various participants. Considering how little real money must be put up, there is a strong parallel today between commodity futures and gambling. At first, it is somewhat surprising that this market situation, as a problem, isn't being talked about in more detail. However, here a parallel can be drawn to my own area of expertise, the fixed income markets. In the media, both fixed income and commodities are treated as some sort unfathomable black hole. Right now, the media loves to talk about commodities because it gives them a positive market amidst all the negatives. Their experts they bring on validate their points all work for commodity trading houses (or trade themselves) and talk up the market. This is what Bill Gross has been doing for years. I don't blame any of them for anything because there are no rules or guidelines in place preventing them from doing so, like the ones that came into being in the equity market after the last stock market bubble.

Before any real damage is done to the economy, the government (you won't often hear me say this) needs to step in to reduce the speculative bid to a reasonable level. While I'm all for people being allowed to throw their money away on stupid investments, there is real risk to the worldwide economy. I would suggest that the CFTC step in and do whatever is necessary to increase margin requirements for speculators (it can do what it wants with hedgers). The futures market was supposed to provide price discovery for cash market participants, as well as providing a hedging vehicle. That isn't happening anymore; the futures just drag the cash higher, regardless of supply and demand. In a perverse way, market forces are being co-opted by the speculation crowd. Investors are piling in to relatively small commodity markets, pushing them ever higher and therefore creating more equity for those in first. Because of the extreme leverage, it behooves the market players to get more and more investors at ever higher prices. I have yet to hear anyone say that these are the correct prices for any commodity currently, only making vague statements in reference to the abovementioned EM middle class. I wouldn't want to liken the commodity markets to a Ponzi scheme, but this and every other bubble in the history of mankind have had similar characteristics.