Commodity prices have held up rather better than might have been expected given the recent run of bad news on the US economy, which has hit equity markets much harder. The resilience of commodity prices has been supported by gains in agriculturals, notably sugar and soybeans, due to renewed supply concerns. But even the prices of commodities which are more sensitive to the economic cycle, such as oil and copper, have edged down recently.
The most likely explanation is speculation that the US Fed will be forced to implement a third round of Treasury purchases (QE3), or at least that it will keep interest rates near zero for longer than others (although not Capital Economics) had previously anticipated.
Ultra-loose monetary conditions are, of course, particularly helpful for commodity prices because they minimise the opportunity cost of holding assets that do not pay any interest, while increasing demand for hedges against inflation or further dollar weakness. This argument is often backed up by variations on the Chart, which at face value at least imply a strong relationship between the Fed’s holdings of Treasuries and the level of commodity prices.
However, we are unconvinced for three reasons.
First, it seems premature to anticipate further QE. The US economy has slowed, but it has not collapsed. Some of the headwinds, notably the previous spike in gasoline prices and the disruption to supply chains from the Japanese earthquake, should fade in the second half of the year, allowing growth to pick up again. In the meantime, core inflation, although low, is ticking higher.
The Fed’s decision to launch QE2 was hugely controversial, even among some FOMC members, and it will take a lot more weak data to prompt serious consideration of a third round of Treasury purchases. Indeed, the prospect of another surge in commodity prices might be another reason for the Fed to pause before implementing QE3.
Second, in the conditions when the Fed might be willing to ease further, demand for commodities from end users is likely to be very weak. The US would probably have to be sliding back into recession, or facing an imminent threat of a slump as fiscal policy is finally tightened. The global economy would presumably be struggling too.
It would then seem unlikely that the institutions selling government bonds to the Fed would readily reinvest the money in much riskier commodities, or that others would be eager to increase their exposure to commodities either (the safest havens like gold excepted).
Third, even if the Fed does launch QE3, the dollar could still rebound. For now, shifting expectations for monetary policy are driving the US currency lower. But this would change if, as we expect, the financial crisis in the euro-zone deepens and the dollar benefits from a revival of safe haven demand.
Overall, whether or not the Fed launches QE3, we continue to think that financial conditions will remain favorable for commodity prices for a long time yet. However, this will not be the whole story if, as we also expect, the world economy faces several years of sluggish growth and the dollar recovers.
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