Commodities Sag, but Why?

The punishment that financial markets have been doling out recently has finally hit the last bastion of strength: commodities. Most believe that the decline in everything from oil to corn to wheat is the result of investors raising cash:

Investors with losing trades in credit markets -- mortgage bonds or collateralized debt obligations, for example -- are being required by banks and others to set aside more cash to cover the money they borrowed to make trades, a process called "deleveraging." To raise the cash, some investors and hedge funds have sold some of their commodity winners.

"It's a classic deleveraging trade," says Bill O'Neill, a partner at investment-advisory firm Logic Advisors in Upper Saddle River, N.J. He says the unwinding of winning commodity trades has been playing out for most of this week, especially in the first half of the week.

Others give the victory to Bernanke:

Investors who had poured money into gold, oil and corn, seeking a hedge against inflation and a weak dollar, sold commodities to raise cash or buy stocks. The Reuters/Jefferies CRB Index of 19 commodities tumbled 8.3 percent this week, the most since at least 1956, after touching a record on Feb. 29.

``Bernanke took care of the commodity bubble,'' said Ron Goodis, the retail trading director at Equidex Brokerage Group Inc. in Closter, New Jersey. ``Commodities are coming back to earth. The stock market looks OK, and Bernanke is starting to look a little better.''

Concern that the central bank would let inflation get out of control eased after the Fed cut its key interest rate by 0.75 percentage point on March 18, less than the reduction of at least 1 point that investors had expected.

I think there is more to this than de-leveraging and investors respecting Bernanke's inflation-fighting prowess. I believe that investors are beginning to call into question the strength of global growth and sensing that it is simply not credible that India, China, Brazil and other engines of growth around the world will remain oasis' of prosperity when the world's largest economy (though technically smaller than the Euro-zone thanks to the weak dollar) experiences significant financial stress. Remember just 10 years ago Russia defaulted on billions of dollars of debt (remember LTCM) after the Asian crisis led to a global slowdown that pushed oil prices down to $11 a barrel and took away a major source of income for the Kremlin. Now oil prices are 10 times that on the back of one of the longest episodes of global growth on record. There is certainly plenty of room for commodity prices to fall further, especially if we start to see the slowdown in the US spreading more aggressively to the rest of the world.

Hat Tip: WSJ and Bloomberg