US inflation data has been critical for the market outlook and what the Fed does next, perhaps none more than commodities. After a multi-month pause, are commodity prices ready to resume the early 2021 rally?
WHAT’S NEW? US inflation
Today US CPI (consumer price inflation) was reported as growing 5.3% in August, down only slightly from the 5.4% prints in June and July (a 13-year high). The monthly growth was 0.3% compared to 0.5% prior and missed estimates of 0.4%. Core prices, which strip out food and energy painted a similar picture, growing at an annual pace of 4.2% compared to 4.3% prior.
Commodity price reaction to CPI
The kneejerk market reaction to monthly inflation data tends to be via the bond and currency markets, which in turn influence commodities. Simply put, higher US inflation tends to mean a stronger US dollar and weaker commodities because they are priced in dollars.
That’s not the bigger picture though. The US dollar has held its own in 2021 but overall remains very depressed given the sky-high inflation.
While inflation data continues to surprise to the upside according to the Citi inflation surprise index, the dollar index (DXY) has traded sideways for much of the year.
What’s happening with commodities?
The Bloomberg spot commodity index just hit its highest level in 10 years.
Having crashed during the onset of the pandemic, commodities went vertical throughout 2020 and the first quarter of 2021. Now after pausing for a rest, a breakout to new decade highs in the Bloomberg spot commodity price index suggests bulls are back in charge.
So in comparing the prices of commodities and the US dollar over the past year, we can say that investors appear to be pricing in inflation through commodities rather than currencies.
But are these commodity price rises sustainable, or are we close to a top?
Why are commodities rising?
Rising commodity prices are one the main driving forces behind the rise in producer prices and in turn consumer prices.
- Supply and demand
Commodities are benefitting from a perfect cocktail of supply shortages caused by disrupted production during lockdowns in 2020 and pent up demand in 2021 as economies re-open, which has caused US freight rates to rise at the fastest annual pace in 15 years.
- China / OPEC+ Intervention
China’s emissions crackdown alongside huge stockpiling in 2020 has led to significantly lower metals output from the world’s biggest steel and aluminium producer. This is a state-backed reduction in supply, just like in the oil markets with OPEC. OPEC+ which includes Russia continues to limit the supply of oil, leaving the oil market in deficit.
- Central Banks
The muted reaction in currency markets to higher inflation makes sense because central banks have promised to keep interest rates pressed to floor, even continuing to buy up huge swathes of government bonds with printed money. For now the causal relationship that higher inflation leads to higher interest rates has broken down because of ultra-accommodative monetary policy and a convergence of policy among central banks. For speculators, that only leaves one market to express higher inflation expectations - commodities.
Which commodities are rising?
Commodity price indices disguise differences within the commodity complex. Some commodities are hotter, some cooler.
Aluminium just hit a fresh 13-year high at $3000 per tonne, caused by a coup in Guinea, which is disrupting bauxite production.
Nickel prices have reached the highest levels since 2014.
Iron ore is a different picture - the cut in demand for the raw materials of steel from China has seen the price crater by 45% from its highs.
Copper has stabilised above $4 per lb after nearly touching $5 in May.
Gold & silver flash-crashed in August but have since been rising Gold is hovering around $1800 per oz, still well down from its record high of over $2070 twelve months ago.
Spot gold chart - 1 year
Natural gas in Europe has tripled this year caused by depleted stockpiles before the winter heating season and carbon emission prices have also been soaring.
Coal has gained over 100% this year precisely because it is so unloved by governments. Production is declining but until renewables are more widely available, coal is still needed.
Crude oil has been consolidating gains, but WTI crude just closed back over $70 per barrel for the first time in five weeks thanks to lost US Gulf of Mexico production caused by Hurricane Eda.
WTI crude oil futures (3-years)
What next for commodities?
How far commodities can go could depend on these possible sequences of events
At some point, post-pandemic demand will cool off and supplies will catch up. Supply bottlenecks will end, shipping rates will come down and economic growth will slow. For what its worth, OPEC just cut its oil demand outlook for 2022, while at the same time maintaining its plan to lift output each month through the end of 2021. This narrative fits in with what the Fed has termed ‘transitory’ inflation.
Under this scenario, commodity prices could remain elevated for a while but would turn lower once things ‘go back to normal’.
Inflation starts to bed into the mindset of producers and consumers, then commodities will need to keep rising to reflect higher costs of production and labour. A high spending agenda in Washington DC could propel this forward. In a rising inflation environment, investors typically also want to protect themselves in hard assets, including commodities.
This would be positive for commodities and could help usher in a breakout to new highs in the gold and oil charts above.
This is the gold bug super scenario. High inflation persists but the Fed cannot lift interest rates enough to combat it without sending government borrowing costs soaring and risking a US national default, so the Fed loses control and inflation turns to hyper-inflation.
This is when we start talking about gold at $5000 per oz etc.