Commodities Trading Is Banking's New Battleground: Matthew Lynn
Comment of the Day

May 11 2011

Commentary by David Fuller

Commodities Trading Is Banking's New Battleground: Matthew Lynn

This is a topical item by the Bloomberg columnist. Here is a middle section:
Lives at Stake

It would be easy to dismiss those protests as nothing more than the complaints of a few anti-business fringe groups and grandstanding politicians. Easy, but wrong. In reality, there is a serious issue here. Speculation in commodities isn't like trading in financial instruments. People don't eat Nestle SA (NESN) shares. They don't need Treasury bills to keep their factories running. The prices of those instruments can jump around like crazy without it affecting people's lives.

But when the price of wheat or copper soars, it makes a big difference. Some people can't afford to eat anymore because food is too expensive. Companies that used to be profitable start losing money and firing workers because the cost of their raw materials has risen so much. If they think the banks are to blame for that, they will be angry.

So what should the banks do? There are four things they should try to do to maintain public legitimacy for this business.

Supply and Demand

First, explain that it isn't speculation that drives prices higher in the long run. It is supply and demand. For every buyer of a futures contract there is a seller. So while prices may be more volatile, they don't change the general direction of the market for long.

Two, shift the blame. It isn't necessarily traders who are pushing up commodity prices. It is just as plausible that monetary policy by central banks is the culprit. Quantitative easing creates more money, and it has to show up somewhere. Private bankers shouldn't take all the criticism when it may well be the government's bankers who are guilty.

Three, explain that commodities are now an investment class of their own -- and a pretty good one as well. Over the next decade, returns from equities may be restrained by heavy regulation, a legacy of the financial crisis. Bonds don't look a much better bet: Most major countries are struggling with sovereign debts and inflation, both of which are bad for bonds.

David Fuller's view As a private investor, I have traded commodity futures quite actively since 1972 when I first acquired a little extra 'seed corn' to fund margin requirements. I was lucky in my entry date because it was shortly after the last commodity supercycle commenced.

Fullermoney has steadfastly maintained that another commodity supercycle commenced around 2001, and that it would be longer than the earlier cycle which ended in 1980 due to Paul Volcker's monetary tightening and successful effort to wring inflation out of both the economy and public consciousness.

Briefly, this commodity supercycle should be bigger and longer than its 1970s predecessor because so many more countries are participating, led by China. Their success is facilitated by the adoption of capitalism in the last two decades, plus the transfer of technology due to globalisation. The global population is also much larger. In contrast, easily accessible industrial commodities are less prevalent than in the 1970s.

A commodity supercycle of a generation or more could only occur simultaneously with a global GDP supercycle. This too is apparent, as vastly more people around the world aspire to join the middleclass, and are succeeding. Incidentally, supercycles are interrupted by recessions, as we saw in 2008-2009, because there will always be a business cycle. Also, commodities are notoriously volatile and a corrective phase has commenced recently as this weekly chart of the Continuous Commodity Index (Old CRB) clearly indicates.

My long-term personal view is that commodity speculation, which is obviously done for profit, generally has the unintended virtue of increasing liquidity in resources markets. This can be beneficial for the actual users and producers of commodities, in terms of their hedging requirements.

For decades I have argued and demonstrated that commodity speculation usually narrows trough to peak cycles in the markets. Successful speculators buy when prices are low, which helps producers in their time of need, and sell high when supplies are scarce. For commodities which are not traded on futures markets, peak to trough swings are generally greater because there is no speculator to create the additional liquidity.

At least that is the way it used to be. However, as more financial institutions choose to invest in commodities - from banks to hedge funds and even endowment funds, plus the public piling into trackers, their positions are outweighing dealing by the 'trade', known as the producers and consumers of commodities.

In other words, the tail is now wagging the dog, with real economic implications because with the exception of monetary metals, these commodities were obviously never meant to be asset classes.

As for Matthew Lynn's points under his 'Supply and Demand' subheading, I do not think these hold up: 1) Of course speculation drives prices higher if there are more buyers than sellers; 2) Yes, very loose monetary policy is a factor but long-term investors may wish to consider commodity shares rather than commodity trackers, in the interests of their overall portfolios, otherwise their actions contribute to short-term inflation and longer-term deflationary pressures; 3) Commodities are not an asset class just because bank PR departments declare them so.

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