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If you were to look at the action in a host of physical commodities over the last month you wouldn’t come away with a patently deflationary view, as sharp declines in the US Dollar have provided some lift to a select group of commodities. However, we have to wonder if the recent bounce in certain commodities isn’t a false dawn brought on almost exclusively by currency related arbitrage buying in the wake of a strong reversal in the US Dollar. While some physical markets have forged impressive bounces (corn almost +$1.00, crude oil +$10, gold +$160), the classic economic readings from the US and the world have fallen apart over the last month. Certainly some physical commodity prices are being lifted by inflationary expectations in the wake of unprecedented reductions in US interest rates, but even that type of buying interest probably can’t be sustained without an improvement in the global economy.
Make no mistake about it, one must recognize the long term inflationary ramifications that are building into the current structure, but we continue to see too much evidence of declining demand and rising supply to think that commodities have already embarked on a sustainable recovery track. In the energy complex (which has dominated most other commodities for the last five years) we are seeing signs that supply is starting to build on ships (a float supply), and that suggests that demand destruction psychology isn’t being overstated and that the end result is that physical production is exceeding physical demand. In the grain markets recent government reductions in feed and export demand don’t appear to have been fully manifest in the supply and demand balance sheets, and while a private forecaster recently predicted a sharp decline in upcoming corn acres, we doubt that forecast will stand in the event that December 2009 corn hovers in a $4.20 to $4.50 range into the planting decision window. Demand concerns have also reached a high enough level in the industrial metals complex, and major world producers have announced aggressive capacity reductions. While that could ultimately be the source of a major bottom in industrial metals prices, we think it will take signs that the deterioration in the economy is starting to slow before base metals prices turn up in earnest. The positives are that US borrowing costs have fallen dramatically, that the US is almost spending $1 billion less per week on gasoline than it was in July and that the US government is committed to throwing everything but the kitchen sink at the problem.
Clearly the action in the US equity market over the last month suggests that some players are seeing through the blizzard of dismal economic conditions to the prospect of better times ahead. However, we think that the deterioration in the US economy is set to reach a crescendo into the January 9th unemployment report for the month of December. While we also expect the January unemployment report to show a moderately large job loss, it is possible that the rate of deterioration will slow. Traders should watch for significantly lower oil prices and a noted dive in long term mortgage rates, as those forces could become the genesis of a long process of repair. In the near term, one can’t rule out the prospect of residual gains in the commodities that are sensitive to further weakening of the Dollar, but buying commodities exclusively off Dollar action could prove to be a slippery slope.