Get Real

The "I told you so" crowd is out in force, decrying right and left everything about the United States: its government; its economic system; its regulatory bodies; on and on et.al. I'm not looking for a backlash so I will refrain from naming names, but it is the usual US bashing cadre; you know who they are. Fortunately, the pilers on, the stock jockeys that were all over the Fed for not cutting rates to zero back in August, have stayed on the sidelines (In fact, those people are now engaged in a love affair with the Fed). This time it is inflation that is the bee in the bonnet.

Inflation is a problem. Certainly, it is much higher than the official statistics being reported. However, the United States and its economy are flexible and resilient. Competition, the availability of substitute goods, etc. all help out. Clearly, not everything is substitutable, but the US will manage. Other countries have fewer options, particularly poorer ones. At the margins, faced with the choice of filling your car with gas or eating, guess what wins out. Serious unrest is certain to occur, and then no one wins. The standard mantra coming out of "the crowd" that emerging market growth is driving prices higher is almost completely nonsense. There is no reasonable justification for the meteoric rise in the price of commodities. It is time for this inflationary burst to be exposed for what it is, a plain old bubble.

Commodity futures were initially established to allow cash market participants the ability to hedge themselves against adverse market moves. Later on, a price discovery function developed, again with the idea of supporting the cash market. In recent times, as futures markets participation became easier, more and more investors jumped in, considering the small investment (relative to the cash market, the investment is negligible) required. Derivative and related securities became available, increasing the number of players. Meanwhile, the markets size and liquidity hasn't to the same degree as the level of participation. Given the pain that commodity price moves have caused and will cause, why hasn't there been the hue and cry from the usual sources as to the root cause of the problem? The reason is that all the players involved in the market are benefiting, a classic bubble scenario.

First, "the crowd" keeps telling everyone these moves are demand driven. Either they are quite naive, or they are trying to manipulate the market. Given that "the crowd" are the largest speculative element out there, I would choose the latter. Second, demand in the largest market, the US, is declining. Some of the declines are greater than reported. For example, the oil component of gasoline is down more than the absolute numbers gasoline usage. Why? The use of ethanol in gasoline is steadily increasing. Ethanol is significantly cheaper than gasoline. This is why refiners keep producing gasoline, even though the widely reported "crack" spread is hovering around zero to negative (if it was negative, there would be little incentive to produce gasoline). Fewer houses being built means far fewer of the commodities used in their production are being consumed. I won't even go into agricultural commodities, where price rises have been dizzying. There isn't that much ethanol being produced to justify a quadruple increase in the price of wheat. Third, and most important, is that everyone in the market is making money. As a trader, it is not hard for me (or anyone) to make money in a one way market. Producers simply lift their hedges or don't put them on in the first place. Consumers go long the contracts, benefiting from the price rise. As supply of contracts from fewer actual hedgers goes down while demand for contracts are increasing, guess what to the contract price? Big speculators go along for the ride, pushing contracts even higher, and then go out to the real world and sell the worldwide demand idea. This is a trader's paradise: put forth little effort and capital, and ride a one way market.

It is time to get real. For example, if the real price of oil should be $110, then the US would be self-sufficient in oil, tapping all of the shale reserves out West at $75-$80/barrel. The government is stepping in everywhere else these days. It needs to expose what is going on publicly,and take the speculative bid out of commodities (significantly raise the margin requirements for not cash market participants). Otherwise, there will be a massive inflationary spiral, which hurt all or a bubble bursting deflationary scenario that, while wouldn't be such a bad thing for the US, would be disastrous for the rest of the world.