At The Source, the Wall Street Journal's economics blog, Alen Mattich raises the dicey question of whether commodities can hit a liquidity trap.
Currently, the economy looks like it's stuck in a deflationary rut – because of the low velocity of money leading to a liquidity trap. There's no shortage of dollars – indeed, anyone buying gold futures and silver futures probably feels the opposite way – but the conviction of falling prices and the general uncertainty infecting the economy create a situation in which no one is willing to lend or spend that money.
On the flip side, writes Mattich, when interest rates are very low, investors have a strong incentive to hoard real assets like commodities. That's exactly what's happening with gold right now – everyone sees zero interest rates, predicts inflation and stocks up.
John P. Hussman, of Hussman Funds, wrote Monday in an investment note that "The tendency toward commodity hoarding is particularly strong when economic conditions are very weak and desirable options for real investment are not available. When real interest rates have been negative and the Purchasing Managers Index has been below 50, the XAU gold index has appreciated at an 85.7 percent annual rate, compared with a rate of just 0.1 percent when neither has been true.
If the Federal Reserve engages in further quantitative easing, it's likely to result in a further flood of money into both commodity futures and the underlying physical goods. That, in general, has a negative effect on the whole economy: Pricier grain futures or crude oil futures might be good for the people who grow or extract those goods, but the price is passed on to society at large.
The end result is volatility – as always, when the fate of the underlying currency pricing these commodities is in doubt, commodity futures brokers and traders get nervous, and when professional investors get nervous, things can get unpredictable, fast.
That's why it's important to understand long-term trends as well as short-term trends, and to see which commodities are trading primarily on a monetary basis and which are moving off of fundamentals. In addition, it's relatively difficult to manipulate the fundamentals behind a commodity – a sudden increase in the supply of, say, silver or copper tends to come from a combination of good fortune and long-term investing.
Currencies, on the other hand, are the creation of central banks – the Federal Reserve can buy as many bonds as it wants to with freshly-created money. That means the savvy commodities investor has to consider the potential future actions of the world's central banks as well.
An investment strategy that relies too heavily on continued low interest rates or a continually appreciating yen might suddenly find itself upside-down following an unexpected change of strategy. Of course, the same can happen when a storm hits the Gulf of Mexico or a copper mine collapses – but in today's macroeconomic environment, investors are more worried about central banks than Mother Earth.
The risk trade can deliver substantial returns – but it has that name for a reason.
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