4th August 2010 by Shaun Richards
Following on from the recent signs of weakening in the US economy we got some more economic evidence on this front yesterday. Pending home sales were -2.6% and were followed by factory orders of – 1.2%, just to add to the gloomy picture the figures for June durable goods orders were revised down from -1% to -1.2%. The figures for both personal incomes and personal expenditures were flat leaving personal savings at 6.4%. All of these were worse figures than expected but the one that caught my eye was the personal savings rate figure which is quite a change on the pre credit crunch era. also it is edging higher. This has two effects firstly it takes demand out of the economy and secondly it may provide at least a partial explanation for the surprising levels of government bond yields I have written about recently.
One instrument that is being affected by the recent poor figures on the US economy is the US dollar. I wrote yesterday about its fall against the pound to 1.593 but it is also now at 1.32 versus the Euro and 85.53 versus the Japanese Yen. This leads me to two main thoughts. The first is that we have a partial explanation for the weakness in the Japanese Nikkei 225 equity index as the strength in the Yen affects Japans exporters. This trend which has pushed the Yen near to what would be a 14 year low also to my mind is an explanation of why the Nikkei fell by 204 points overnight to 9489. This means that the difference between it and the Dow Jones Industrial Average has risen to 1147 points or 11.7% of the Nikkei’s value. The second is how quite the news media have been on the fall of the dollar versus the Euro. It was not so long ago the Euro’s fall was being trumpeted in some quarters as being a signal for the end of the euro zone, on the same logic the euro zone should be benefitting from articles praising it.
What is happening with Commodity Prices?
This factor has come to my mind as we have seen rises in several commodities recently. The financial press is currently looking at the recent rises in the price of wheat which due to a severe drought in Russia which is apparently the worst for a century and too much rain in Canada is rising because it expects a shortfall in supply. On Monday the price of wheat rose to above $7 for a bushel of wheat before closing at $6.93. Looking at the year so far wheat prices fell up until June and since then have risen so reports of a 60% rise since June need to be taken with a pinch of salt. However we are up now from around $5.50 at the beginning of the year.
This move by wheat comes on top of recent rises in the price of sugar which has risen by around 38% over the past two months. We have also seen movement in the price of cocoa and the rather extraordinary move by one investor to control 7% of its supply. Coffee prices have also risen by around 30% this year.
The Commodity Research Bureau Index
Seeing moves in individual markets makes me take a look at the spot index calculated by the CRB which is a measure of overall commodity prices. The CRB calculates a spot index which has the following components in it.
Metals: Copper scrap, lead scrap, steel scrap, tin, and zinc.
Textiles and Fibers: Burlap, cotton, print cloth, and wool tops.
Livestock and Products: Hides, hogs, lard, steers, and tallow.
Fats and Oils: Butter, soybean oil, lard, and tallow.
Raw Industrials: Hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, rosin, and rubber (59.1%).
Foodstuffs: Hogs, steers, lard, butter, soybean oil, cocoa, corn, Kansas City wheat, Minneapolis wheat, and sugar (40.9%).
In case you were wondering (like me!) burlap is a type of hessian so it is a measure for rope/cloth. However the index has been calculated in its present form since 1986 with a small modification in 2003 to the definitions for zinc and copper. So it has a track record. It is not perfect in the way it is constructed but the methodology is to pick raw material prices as explained below.
The commodities used are in most cases either raw materials or products close to the initial production stage which, as a result of daily trading in fairly large volume of standardization qualities, are particularly sensitive to factors affecting current and future economic forces and conditions………
It does this as it feels that these will be the quickest to change as economic circumstances change. For those unaware of what a spot price is then.
A spot price is a price at which a commodity is selling for immediate delivery
So we have now an index which is a measure of price pressures at the beginning of the production/food chain. There are other variants of the same thing but the spot price is the most basic.
What is it telling us?
On Tuesday the spot index rose by 4.87 to 440.48. If we look back the recent low was just below 300 in December 2008. Over the past year the spot index has risen by 18.3%. Prices in this series ebb and flow to a degree as commodity prices are often volatile but the recent move upwards began at the beginning of July. Furthermore since the middle of July the metals component has been a major contributor to the overall index rise as it has risen from below 720 and it continued this trend yesterday as it rose by 27.75 to 781.8. So it is not only foodstuffs which are rising.
There is no automatic link between a rising CRB index and inflation but recent movements do suggest that there are some inflationary trends in the system. This sits rather oddly with the current world obsession with deflation and disinflation to my mind. I do not see why stagflation as a possibility has been ruled out by so many.Perhaps they have been staring too hard at their output gap theory charts again, a theory which in the UK has performed poorly over the credit crunch and if you look at my update on US inflation on the 2nd July may not have performed so well there either. Perhaps they have been looking at the worlds major government bond markets and their yields.
Government Bond market yields seem to be predicting deflation and perhaps disinflation
The counterpoint to the fact that the world does appear to have some inflationary trends in its system is the behaviour of government bond yields. I have written about this each day this week but today the moves come as a counterpoint not to equity markets (although to my mind the point remains true) but to commodity price trends. Over the period commodity prices have been rising so have government bond prices.
Yesterday the yield on ten-year US government debt fell to 2.89% and the ten-year UK gilt yield fell to 3.28%. The yield on two-year US government debt is now 0.53%. Now some of this is being driven by expectations of a move towards some more monetary stimulus measures by the US Federal Reserve on August 10th but the way that yields are being driven lower is quite remarkable. If the famed double-dip does not occur then this will be looked at in history as an extraordinary bubble in bond prices.
As ever the most extreme example of this is Japan where this morning something happened which even in the fevered state of bond markets and allowing for her prolonged period of disinflation surprised me. Her ten-year government bond yield touched 0.995%. For those who do not follow her fiscal position she has an extraordinary amount of issuance to undertake this year of around 50% of her Gross Domestic Product and yet this market ignores this and rallies.
The world picture at this time continue to be one where markets are fixated on what I call the “outliers” of probability. Whilst it looks as though the US economy is slowing this does not guarantee it will fall off the edge of a cliff as government bond markets are assuming. If it does not fall off the edge of a cliff many recent bond purchasers are going to regret their purchases.
The deflationary/disinflationary side of the argument does not have any room in it at all for the recent rise in commodity prices. Now this is a complicated picture because as these commodities are priced in US dollars the falling US dollar will help everyone except the US deal with this. Then of course you have world equity markets whose recent rally gives a completely different picture.
Overall maybe the clearest message is one of confusion and uncertainty as each market appears to be predicting a different outcome.