Vol 1/11, 1 October 2010


In recent months, global commodity prices ranging from precious metals to grains to cotton have risen dramatically, notwithstanding signs of moderating economic activity. Is this due to constrained supply or simply a weaker dollar? We find these explanations inadequate because commodity prices are rising in all currencies and relative to both stocks and bonds. This is highly unusual and suggests that investor preferences have shifted in favour of commodities for some reason. But why? We believe we know the solution to this mystery.

When a young child is caught in a lie, they deny it. As they grow, they find ever more elaborate ways of deceiving their parents, only to be caught out time and again. Finally, as a teenager, they give up trying to deceive and begin simply to blame their parents for their transgressions, rather than take responsibility. Recent statements by Federal Reserve officials suggest that, following a long childhood, the Fed has now entered its teenage years.
THE MYSTERY OF RISING COMMODITY PRICES In recent months, commodity prices have risen dramatically. From a low point reached in June, various broad commodity indices are up from 1520%. Few components have not participated in this rally to at least some extent. While commodity prices are individually quite volatile, when placed in a broad, diversified, basket, their volatility is comparable to the stock market. So this recent rally is significant. Moreover, it is occurring alongside signs that the global economy is beginning to slow, which is the opposite of what one would normally expect. Leading indicators in the United States and Japan have turned decisively lower, while those for Europe are moderating. Economic policymakers in all of these areas have expressed concern that the risk of a double-dip is rising and in several instances they have backed up rhetoric with action: · The US Fed has openly discussed plans to add additional stimulus to the economy, most probably in the form of increased US Treasury purchases; · Japan intervened aggressively in the foreign exchange market in September to weaken the yen · Euro-area officials, including Eurogroup Chairman Jean-Claude Juncker, have expressed concern that euro strength is now excessive and threatens the recovery And it is not just the developed economies that are concerned. Emerging economies, including the

largest ones known as the BRICs (Brazil, Russia, India, China), have moved toward a united front in resisting further dollar weakness versus their currencies, concerned about the negative impact that this would have on growth. Last month, Brazil’ s Finance Minister Mantega went so far as to declare that a currency “war” had begun, with the developed economies seeking to devalue versus the developing. So this presents a bit of a puzzle: If growth is weakening, why are commodity prices rising sharply? After all, demand should be weakening. Stockpiles should be increasing. Producers should be cutting, not raising prices, correct? What is the explanation? Well up to now we have only concerned ourselves with the demand side. What about the supply side? Are their factors constraining supply? Let’s consider a handful of the more widely traded commodities. First, the largest of them all, crude oil. Crude oil and distillates thereof comprise 65% of the Goldman Sachs commodity index (GSCI), reflecting their huge relative volume in the global commodities trade. Have there been supply issues with crude oil recently? No, 1 there haven’t. And in fact, the price of crude oil has not risen by much over the past few months. From a low of around $75/bbl in June it has risen to $85/bbl, a 12% rise, which given the normal volatility of crude is not notable. As the most important industrial

The BP Gulf of Mexico oil spill disaster may have dominated the oil headlines for a few months but as it did not involve a producing well, the spill had no impact on global crude production, distribution or refining.


1 October 2010 www. relative to certain currencies. coffee. demand for commodities generally has been rising. Once again we must ask ourselves the question.THE AMPHORA REPORT Vol 1/11. the base metals. Dollar weakness may be a partial but certainly not complete explanation for the recent. Second. the dollar. with hogs prices flat and cattle prices rising a modest 5% since June. However. both have risen about 20%. if the global economy is beginning to slow down. let’ s turn to the next most important industrial commodities. including the Swiss franc and Australian dollar. sharp rise in commodity prices. This past week. S&P 500 equity index. used in all manner of production across the globe. Commodities have strongly outperformed since June (%return) DJ-UBS broad commodities index. Hardly any are down. nearly all commodity prices are up. cocoa and cotton are also widely traded agricultural commodities. we must conclude that. only cocoa has not risen significantly in price. such as the Swiss franc. Since June. of which aluminium and copper are amongst the most widely traded and are used in a broad range of industrial applications. none of these has been directly affected by supply issues to the extent that grains have. Some are up sharply. The prices of grains began to rise sharply in July. when it became clear that the Russian wheat crop was suffering severe damage from widespread wildfires. So this price behaviour is at odds with crude oil and requires further commodity. Could it be that commodity prices are rising primarily because the dollar is falling? After all. These are clearly supply issues which could be considered mostly if not completely responsible for the rise in grain prices.amphora-alpha. because broad indices of commodity prices are up by 15-20% over the period. Supply issues certainly have affected certain commodities but not others. Now let’ s turn to agricultural commodities. relative to other major economies with which the US trades. the dollar has weakened by about 5% since June. namely. the fact that crude oil prices are not up by much suggests that global economic growth is no longer accelerating. is at or near record lows. As such. there haven’t. somewhat more than the modest rise in crude oil prices. at the margin. that is. which is unusual. And they have risen slightly even relative to even the strongest currencies in the world. grain prices soared again when the US Department of Agriculture (USDA) issued a report indicating the US grain production would disappoint this year. So does the weaker dollar explain the broad rise in commodity prices? No. Looked at in trade weighted terms. in particular grains and precious metals. at least slightly. US Treasury total return index Source: Bloomberg LP 02 . the dollar has declined versus most currencies during the past few months and. Canadian and Australian dollars. Sugar. of these four. In recent months. Have their been base metals supply issues? No. To summarise. why are commodity prices rising? This discussion has yet to discuss the denominator of these prices. by 2-3% in both cases. Livestock prices have been mixed.

is there anything left? Where might we look for clues to help us solve this mystery? As with all prices.amphora-alpha. Historically. implying that gold is being re-monetised. supply issues and the weaker dollar as potentially full explanations separately or together. But what possible source is there for commodity demand that is not in some way related to industrial production or consumption? Is there a solution to this mystery? Yes there is. we have demonstrated that broad commodity prices are rising relative to both stocks and bonds. a full explanation for the strong rise in commodity prices of late. Second. we have eliminated industrial demand. for the sharp rise in broad commodity prices in recent months. All we need to do is look at relative commodity prices to see which have led in the outperformance. Evidence for this is provided by data showing that scrap jewellery has been returning to the market and the production of new jewellery has declined. The World Gold Council tracks a wide range of data related to gold mining. after all. or much worse. notwithstanding the supply issues with grains. Precious metals outperform even amidst grain supply shocks (%return) DJ-UBS broad commodities index. 1 October 2010 www. jewellery production. are those that ultimately determine whether we are going to trade one thing for another. stocks tend to perform best and. various supply issues and the weaker dollar as providing. bonds outperform. an unusual development. A broad basket of commodities is normally caught somewhere between the two (although naturally one or two commodities might do much better. First. gold demand has been dominated by the jewellery market. is key to 2 solving the mystery of outperforming commodity prices generally: With supply issues confined to gains. But with industrial demand not increasing and possibly slowing. when investors are optimistic for growth. This is because. What we find is that. which is unusual. although the World Gold Council reports that. rising demand must be the factor driving prices Having determined that industrial demand. Their research reports can be found at here. separately or together. Gold ETF. we can understand much more about why they are rising and falling when we place such moves in context of other. Relative prices. that is. demand for bullion has risen sharply 2 relative to that for bling. So let ’s take a look at what has been happening in commodity prices relative to those for financial assets. Silver ETF Source: Bloomberg LP Demand for precious metals is not primarily industrial. The only conclusion that can be drawn is that demand for commodities is rising for some reason other than industrial demand. although silver does have a broad and growing range of industrial uses. we believe. for specific supply or demand reasons). namely stocks and bonds.THE AMPHORA REPORT Vol 1/11. related prices. when investors become more pessimistic. This. What we find is that commodity prices have been rising relative to both stocks and bonds over the past few months. Let’ s now consider our findings. precious metals have been leading the way. over the past year. as demonstrated both by the its way into bullion instead. finding 03 . scrap supply and investment demand around the world.

the Fed remains steadfast in its refusal to accept any blame whatsoever for the near collapse in 2008 of the financial system it regulates. stocks and bonds.THE AMPHORA REPORT Vol 1/11. should prove a superior store of value relative to cash. What possible reason would investors have for hoarding not just precious metals but commodities generally? Well. high-profile example of this was back in the early 2000s when Fed Chairman Greenspan testified before Congress on the desirability of converting Social Security into a system of individual accounts instead. but just as 3 young plants don’ t always survive and thrive. who swelled in number in the recent recession and. fiscal and monetary. we disagree that monetary policy can somehow succeed where fiscal policy fails. discussed at length in the last edition of the Amphora Report. the Bank of Japan intervening to weaken the yen. The proposal came under immediate criticism. that the Social Security Trust Fund was eventually going to run out of funds and that something had to be done. fiat currency cash. as such. vol.1% in September . Even rarer is for a US central banker to voluntarily criticise government policy. That's right. the US economy is clearly struggling again of late. An increasing number of observers no longer believe that the headline US unemployment figure gives a full picture of the jobs market because it excludes so-called “ discouraged workers” who have given up looking for a job and. One could therefore surmise that Bernanke must feel quite strongly about this matter. for example. 4 Bernanke ’s now infamous “green shoots” comments can be found here. The U6 figure includes these workers. which holders could then invest as desired. But with sovereign debt burdens rapidly on the rise and policymakers seeking new and ever more creative ways to artificially stimulate their economies rather than to step back and allow them to restructure and grow naturally. over a year ago. and currency and trade wars thus ensue. This structural malaise can be seen in various economic "imbalances". With the US Fed embarking on a reckless policy of quantitative easing. rising commodity demand must be due to stockpiling– hoarding– not for production or consumption. Now it is rare for US central bankers to criticise government economic policy. 5 relatively recent. pointing out. it might be some time before investors choose to move out of commodities and return to unbacked.amphora-alpha. the Fed is quick to take credit for having saved the system from disaster and for getting the economy back on track. These statements from the Fed Chairman and Treasury Secretary indicate to us that neither understands the structural issues impeding a normal. although normally 5 this is done is an apolitical way . These cannot be printed. Chairman Bernanke was talking about how the “green shoots” of recovery were increasingly 3 evident . the Fed's latest excuse for why the US economy is not performing the way it should is that Congress has been doing a poor job and. That said. titled Welcome to the Recovery. While not entirely unprecedented. when he claimed that it would be wise for Congress to systematically exercise more budget restraint. if ever. then there is no way for investors to protect their wealth other than to hoard precious metals and other commodities. business and consumer confidence remain subdued. which is econospeak for "unsustainable developments". 1/10: If. other than the colossal amounts of freshly printed dollars being thrown at the economy. in which case they are obliged to offer one up. devalued or defaulted on and. explaining much of why this recovery has been so weak. as such. However. More recently. On occasion. that has been thrown at the economy since 2008. however. Commodity prices are rising because investors no longer trust the economic and monetary authorities around the world to protect the purchasing power of their currencies of issue. with the broad unemployment rate U6 having risen again to 4 17. wreaking global economic havoc. other countries are unwilling to allow their currencies to rise. rather than as a response to an inquiry on a specific issue. perhaps in the form of explicit budget rules. which have been adopted by a handful of countries and 6 also several US states . rather than fiscal policy. that is. He stopped short. we doubt that the hoarding will cease until at least one major economy and most probably several commit to maintaining strong and stable weakness in leading indicators and the relative underperformance of the stock market. By implication. 6 These comments can be found here. of criticising the role Congress has played in building up the Social Security programme through the years. This is because US and to some extent global economic problems are structural rather than cyclical in nature. as such have left the workforce. to provide the stimulus necessary to get the economy back on track. who can blame them? So where does it stop? At what point will investors have hoarded enough precious metals and other commodities to protect themselves? It is impossible to know. his overt disapproval of chronically high budget deficits implies that he believes it would be better for monetary. in the face of a weaker dollar. 1 October 2010 www. which includes fiscal policy. consider the topic of the “ Currency Wars”. healthy US economic recovery. We’re not sure exactly what was green. On track? Well. A quid pro quo of an independent Fed is one that leaves the President and the Congress to their political business. US Treasury Secretary Geithner published a pep-talk on the economy. notwithstanding the extraordinary degree of stimulus. it is certainly rare for a Fed Chairman to exhort the Congress in this way. While we happen to agree with Bernanke that fiscal policy is not the answer to the current set of US economic woes. THE FED’S TEENAGE TEMPER TANTRUM Notwithstanding overwhelming evidence to the contrary. Greenspan tried to support it in his testimony. the Chairman of the Eurogroup complaining that the euro is too strong and the BRIC countries closing ranks against the developed economies generally. notwithstanding the modest rate of positive economic growth over the past year. financial assets generally. continue to increase. Yet this is exactly what Fed Chairman Bernanke did last week. Fed Chairmen have been asked by the President or the Congress to give their opinion on certain policies. 04 .

amphora-alpha. only to find the parent knows better than to believe them. anyone but the Fed itself–Wall Street. it became fashionable to talk about a "global savings glut" which was "forcing" savings into the US. so it seemed that there was no need to raise rates. therefore. So when Bernanke was talking about there being too much savings. the global economy was producing too much. not the rational voice of a sensible. the list grows and grows–and now at the US Congress! When a young child is caught misbehaving. in those years. in other words. as all good parents are. We're sorry. the US has long run a current account deficit. As the child grows. get over it. deceive. Japan. as the US current account deficit grew and grew. but this sounds like a teenage temper tantrum to us. consumer price inflation targeting is a bogus policy. rather than make increasingly elaborate and frequently futile excuses. This argument became. sometimes they attempt to make some simple excuse to talk their way out of it. Bernanke himself used this argument in 2005. by implication Bernanke was claiming that the world was producing too much! That it was. primarily manufacturing economies. holding bond yields unusually low and. then maybe there is some hope after all. Now the Fed is blaming the Congress that created it and lightly oversees it for US economic woes. finds its way into investment. Yes. It is a sign of a teenager maturing into an adult when they not only stop making excuses generally but. neo-Keynesian policy and academic colleagues. stimulating investment in housing and commercial real estate. take responsibility and make the best out of the imperfect situation known as the human condition. present or future. as demonstrated crash in 2001-03.THE AMPHORA REPORT Vol 1/11. even to the extent that they feel their parents are to blame in some way for their foibles. Another identity is that what is not saved/invested is. bewildering and. 1 October 2010 www. were responsible for this "glut" of savings. he was implying either that a) there was too little consumption. led by the US course. bewilder or simply exhaust the parent into retracting an accusation. now including the US. it becomes more common to simply blame the parent! Once upon a time the Fed used to make simple excuses such as "no one could see the bubble". among other areas. Fannie/Freddie. internally inconsistent excuses such as there being a "global savings glut" which the Fed could do nothing about. they move on. If the Fed is indeed on such a path. Money that is saved. for a time. even if put in the bank. consumed. yet one on which Bernanke has staked his academic and profession reputation. say in the form of a commercial loan which a business then uses to finance new equipment or to hire additional workers. the conventional wisdom. However. 05 . So what we have is: savings + consumption = production (GDP) Back in the mid-2000s. China. So therefore it must be the case that. We need only be patient. naturally. in particular the big savers such as China. this remain the explanation to this day for why US aggregate demand is so weak: The world. Amongst Bernanke and his mainstream. As we know. in particular in Asian economies. competent institution ready and willing to take responsibility for its actions past. is saving too much. which was used following the dot. implying that it has been consuming and investing more than it has been producing. this was one of the greatest ever consumption booms in world history. where the household savings rate went outright negative. Now it is one of the basic accounting identities of economics that savings = investment. ASSET BUBBLES OR WHATEVER ONE CHOOSES TO CALL THEM–AND TARGET CONSUMER PRICE INFLATION AT THE SAME TIME! In other words. But do you see the inconsistency in Bernanke's argument? YOU CAN'T MANAGE THE RISKS OF DANGEROUS IMBALANCES–SAVINGS "GLUTS". The net result is a large accumulated debt owed to foreigners. And then. Germany. overheating! So why on earth did Messrs Greenspan and Bernanke not raise interest rates more. and a handful of other. by claiming that there was a global savings glut. arguing that high rates of savings. It must be one or the other. the global economy was consuming too little. when it all blows up in arguably the greatest credit crisis in the history of the Let's place the current set of imbalances in context. Indeed. he has the audacity to assign blame to anywhere. the excuses grow ever more complex in an attempt to obfuscate. Then the Fed began to make increasingly elaborate. was that US consumer price inflation was low. that's right. when a teenager is caught. Now it is farcical to argue that from 2004-2007. or that b) there was too much production. in order to slow the global economy? The answer. we know.

JOHN BUTLER john. Amphora is a registered trading name of Atom Capital which is authorised and regulated by the Financial Services Authority. 06 .com AMPHORA: A lateral-handled. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction.amphora-alpha. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. All express or implied warranties or representations are excluded to the fullest extent permissible by law. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. Prior to joining DB in 2007. where he and his team were voted #1 in the Institutional Investor research survey.THE AMPHORA REPORT Vol 1/11. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it. having worked for European and US investment banks in London. quantitative strategies.butler@amphora-alpha. and under no circumstances shall we be liable for any direct or indirect losses. Nothing in this report shall be deemed to constitute financial or other professional advice in any John Butler has 18 years’ experience in the global financial industry. © Atom Capital. These terms are governed by the laws of England and W ales and you agree that the English courts shall have exclusive jurisdiction in any dispute. New York and Germany. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. where he was responsible for the development and marketing of proprietary. DISCLAIMER: The information. investment products or other financial instruments. 1 October 2010 www.

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