Probably the best market in the world

One of the questions people often ask me, especially if they have no background in economics or markets is why I love following and writing about commodity markets so much. For me its the intersection between so many interesting facets of life that I don’t think you get anywhere else. Here are my top 6 reasons why I find commodity markets utterly fascinating:

It forces you to learn about other topics. In order to really get to the bottom of things you need to have some understanding of human psychology, geology, technology, the weather, economics, demographics, mathematics.

But the learning is never over. Markets have a habit of confounding the most experienced, seasoner observer. I can only count on myself as being somewhere on that journey, one though that is never finished and one I should never think as complete.

There are opportunities. Even the most widely followed commodity markets offer opportunities for insight and profits. Looking down the paths least traveled, and thinking about things in a different way is the way forward.

Its real. Its the ‘Trading Places’ analogy of a breakfast table where the Duke brothers point to the orange juice, the bacon and the wheat to Billy Ray as being commodity markets. Its something that is real and I can explain in very simple terms to my 6 year old, or someone much older.

Writing provides a way of crystallizing your thinking. I will be covering the practicalities of writing in a separate post, but for me the main benefit is that it forces to boil down an idea or some information into a small nugget of insight. From there I can take it somewhere forward that I wasn’t expecting to go before I started writing.

Never a dull moment. Although the talk of the town is low volatility across many different asset classes, its there if you know where to look. And these aren’t some obscure commodity markets, but things like wheat that we all pretty much consume everyday.

My new book Crude Forecasts: Predictions, Pundits and Profits in the Commodity Casino is now available to pre-order as an e-book on Amazon, Kobo, Apple and Google Play. The book will be launched and available to download on Monday 25th September. The paperback version should be available on or about the same day while the audio version should be coming later in the autumn.

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One last hurrah for inflation?

Inflation expectations on the rise in the US. Higher producer and consumer inflation in China. What then of the deflation  that many were fearful of just a couple years ago? Well, I believe the key risk factors that could presage a return to deflation are demographics, a higher US dollar and the deflationary impact from a collapse in industrial metal prices.


Perhaps the biggest deflationary force on the horizon is entirely predictable. And its pretty intuitive why slower population growth, or even outright falls should be deflationary. Although demand growth would typically slow, supply particularly through the housing is very slow to respond helping to push down price inflation elsewhere in the economy. Look at the Japanese economy (perhaps the poster child for deflation) over the past few decades and you will see a strong correlation between population growth and inflation.

Meanwhile, over the next 5 years the ‘Baby Boomers’, those born in the early 1950’s will hit retirement. And while you can argue the notion of retirement has changed for many over the past couple decades there is still likely to be an impact on investing and spending patterns. Retirees will be looking to gradually cash in their chips to fund their retirement. Their spending patterns will also be different. More money focused on experiences than actual physical consumption of material goods. Even the goods that they spend their money on will be different.

One final leg up for the US dollar?

A rebound in the US dollar could also cause a deflationary shock. There have been three broad dollar cycles since the 1970’s. The first reaching a trough in the late 1970’s, the second in the mid-1990’s and the third around 2010. Each of the first two cycles has featured a bounce off the lows of around 20%, a pause followed by a third final leg higher. Over the past couple years there has been a clear pause in the dollar bull market that started around 2010. If the cycle repeats then the next movement in the dollar should be a sharp final movement up over the next few years.

False signals

All of these risk factors is being obscured by the rise in commodity prices and thus inflation expectations. I believe that many commodity prices have been giving a false signal of strong demand growth since the start of 2016 with steel and other industrial metal prices soaring. It just does not make any sense in terms of either cyclical demand growth or ‘typical’ super-cycle timescales (10-15 year down-cycle). Rather it is (mostly) a function of the state mandated infrastructure spending and the threat of capacity cuts by the Chinese and actual cutbacks elsewhere from major commodity producers like Glencore.

Although this policy may have succeeded in bolstering the margins of state producers, it is not a function of the invisible hand of the market, rather the iron-fist of Chinese officialdom. And as priorities change, so could how policy is directed or implemented. We are already seeing Chinese PPI and CPI increase sharply as commodity prices feed through into the real economy. In a country so sensitive to inflation it may not be long before officials start to relax their capacity curtailment policy, resulting in a sharp drop in metal and other commodity prices.

The risk of a sharp slowdown (if not outright recession) in China and elsewhere is also under appreciated. Saxo Bank’s global credit impulse monitor measures the “rate of change of change” of credit in the market. According to the bank the “there is a high probability of a big slowdown in the global economy 9-12 months later – so from October 2017 to March 2018”. Industrial metal prices are particularly sensitive to credit conditions, especially if you consider that past credit growth may have encouraged speculators in China to load up on commodity financing to expand their positions.

What could cause the US dollar to appreciate sharply?

As we are starting to see, inflation expectations in the US are beginning to shift this fall as commodities continue to rally on broad dollar weakness and cuts to capacity in China. The Fed and the market will be forced to rethink the trajectory of the Fed’s rate path, biasing front end yields higher. Positioning on the US dollar will be reaching historically extreme levels by the end of the year increasing the potential for a sharp rebound.

The US Treasury had run down its cash balance sheet to almost zero this year as it neared the federal debt ceiling fixed by law. The Treasury has stated that it wishes to maintain a cash buffer of $US500 billion ($628.6 billion) in normal times, but as it builds the cash balance – by making a permanent -deposit at the Fed – it automatically tightens monetary policy.

What makes the US Treasury actions doubly potent this time is that the Fed is about to pull the trigger on “quantitative tightening” (QT) at exactly the same time, taking the first steps to wind down its $US4.4 trillion balance sheet. The Fed will start by selling $US10 billion of bond holdings each month, rising in stages to $US50 billion a month after a year. This will lead to a corresponding fall in US liquidity and may create the type of dollar shortage that has led to all manner sell offs in commodities and emerging market in the past.

All of which means that if the Fed acts as it has stated it will, then deflation expectations could start to rise much sooner than many expect. Combined with the long term, predictable structural effects in the real economy (ie, the slowdown in population growth and retirement for the ‘Baby Boomers’) then deflationary forces could prove much stronger.

It may just be the case that the recent rise in inflation expectations is what sets it off. A lot depends on central bank policy makers not making mistakes.

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Chinese economic policy uncertainty set to rise

Every five years members of the Chinese Communist Party meet for its Party Congress. The event is typically where the ruling party shuffles leadership and addresses economic reform. Previous meetings have coincided with important announcements on investment in infrastructure. Currently scheduled for this October, the 19th such meeting may also be an important marker board for commodity markets.

Over the past couple years officials have embarked on a series of measures to try and cut production capacity across a range of industries including steel, coal and more recently aluminium. Cuts to domestic capacity have caused seaborne prices for these commodities and others related to them to soar as supply struggles to meet China’s infrastructure investment. One of the aims of these capacity slashing measures has been to improve environmental conditions, particularly those located in urban areas on the east coast that have had to contend with thick smog on a regular basis. However, more pertinent are Chinese authorities attention on financial stability and deleveraging as a critical objective.

Any backtrack on this focus may be a signal that markets may have got too far ahead of themselves. Look for any change in China’s commitment to a GDP target. There is a wide expectation that the Party will reiterate its commitment of doubling GDP by 2020 from the 2010 level, which requires the economy to grow at an average rate of 6.5 per cent in 2016-2020. Also important will be the level of support President Xi’s agenda. If his power is seen as weakened it may be interpreted as a negative for commodity markets and a sign increased volatility.

Previous Party Congress meetings have got some form in dashing expectations for higher prices. The chart below looks back at how copper prices performed before and after the past 5 Party Congress meetings. Copper prices typically rise in the twelve months preceding the meeting, and then peak 1-2 months before declining over the next twelve months to end below price levels seen 24 months earlier.

For sure, previous meetings have coincided with some tumultuous economic events. In 1997, just a few months before the Party Congress, the Asian Financial Crisis was just getting started with Thailand abandoning its currency peg against the US dollar. A series of currency devaluations by other countries in the region caused stock market declines and sharp drops in economic activity. And then in 2007 the Global Financial Crisis got underway as troubles emerged at Bear Sterns and interbank lending markets froze. The knock-on impact on confidence caused copper prices to fall initially and although they later rebounded, further bad news on the scale of the crisis caused copper prices to drop several months after the CCP. Nevertheless, both 1992 and 2012 exhibit the same trend even though China’s importance to overall copper demand radically changed during the intervening 20 years.

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