In recent months, surging equity and commodity prices have helped traders to reap handsome profits from the so-called inflation trade. But recent weakness in commodity markets has raised concerns that the trade may be nearing its use-by date.
It’s little wonder that the inflation trade strategy has been a winner in recent months.
After all, one of the goals of Federal Reserve chief Ben Bernanke’s $US600 billion bond buying program was to drive US sharemarkets higher, in order to boost the confidence of US consumers, which would hopefully cause them to open their wallets.
What’s more, investors calculated that combination of ample global liquidity and gaping US budget deficits would cause the US dollar to plummet, and inflation to surge. To hedge against these risks, they poured their money into hard assets – such as industrial and agricultural commodities.
But prices in some key commodities are beginning to come under pressure.
Gold is now trading at a three month low, its price having dropped by close to 7 per cent this year.
Oil prices have tumbled by more than 5 per cent over the past week, in response to rising US stockpiles, and comments from Saudi Arabia’s oil minister which suggested the country may be prepared to raise production.
And on Tuesday night, weaker than expected UK growth numbers sparked a widespread sell-off in industrial and agricultural commodities, with copper, natural gas and rice futures all dropping by more than 2 per cent, while palladium prices fell 4 per cent. Although commodity markets recovered slightly in trade overnight, the mood remains tentative.
Some blame the move by the central banks – particularly in China and India – for the growing caution in commodity markets. Earlier this week, the Reserve Bank of India raised its key lending and borrowing rates by 25 basis points, its seventh interest rate hike since March 2010. It has also instructed the country’s banks to restrain their lending, and to boost their deposits.
Meanwhile, the Chinese central bank, the People’s Bank of China, has announced interest rates twice in the past three months, and has progressively lifted the level of reserves that banks are required to hold.
These central banks are raising rates and trying to rein in liquidity as they battle against inflationary pressures, causing investors to worry there will be less liquidity available to propel commodity prices higher. There are also worries that higher interest rates will crimp activity in these two fast-growing economies, which will dampen demand for industrial commodities.
In addition, commodity markets are anticipating what will happen when the US Federal Reserve’s $US600 billion bond buying program comes to an end.
The present rally in stock and commodity markets kicked off last August, when Bernanke first started talking about the need to embark on a fresh round of quantitative easing in order to boost the stalling US economy. It got an additional boost once the Fed actually started buying bonds in November.
However, the Fed is now about half-way through its controversial program, and the US economy is showing signs of revival. This makes it unlikely that the Fed will continue the stimulus program past the end of June, when it is due to be completed.
Recent weakness in commodity markets is a clear indication that some traders are already beginning to question whether the inflation trade will fizzle once the Fed’s money printing program comes to an end.
Some believe it will only be a matter of time before the same fear spreads to US sharemarkets.