Predictions of beginning and ending of commodity cycles since the modern day economies emerged from world war two has been more an art than a science. Many economic variables have been tested for their correlative and predictive powers without a consensus over the years. Yet modern studies remain the best because time determines which variables hold up to academic rigor. Any study of commodity cycles can’t find a foundation alone in a commodity nation such as Canada, New Zealand, South Africa and Australia because commodities are priced in US dollars. So understanding periods of commodity boom and busts cycles must be grounded in the US economy as a predictor of future or declining economic activity.
The study of cycles is not a new phenomenon in the modern day. Joseph Shumpeter spent his life studying business cycles and published his classic work Theory of Economic Development in the 1930’s. Scholars, economists, market watchers and traders have since spent their time studying the factors, the variables that make cycles work, the boom and bust, and the tops and bottoms. We know cycles exist. But how do they work. What we learned economically since world war two is not one factor or variable holds up to absolute rigor as a mechanism of prediction of boom and bust. So we will focus on various economic factors with the hope that two or three variables will correlate to understanding booms and bust and possibly predict the future.
The last significant commodity cycle occurred in the 1970’s and lasted from the early 1970’s to about 1980. Most would agree Nixon’s policy to take the United States off the gold standard was a major contributing factor that allowed such a long cycle to perpetuate. Since World War two, economies never experienced such a long cycle. Historically, commodity cycles normally have duration about 10 years. Gold, oil and physical commodities such as wheat, rice, corn and soybeans saw significant and sustained price increases during the 1970’s cycle.. What we learned from this experience and what we didn’t know before because of free floating exchange rates was the U.S. dollar factor.
During periods of US dollar decline, commodity prices and commodity currencies rise. Investors must seek higher yields. They do this by purchasing commodity futures.These factors can be attributed to interest rates. US dollar declines are usually associated with interest rate decreases that presages a declining economy. What occurs many times during these periods is governments experience increased borrowing that leads to extended periods of the downward cycle. This allows the commodity cycle to continue unfettered while governments contemplate exit strategies from recessions.
Boom cycles are quite different. Boom cycles see credit expansions, rising interest rates and rising asset prices. But these boom periods are followed by reversals that normally have tendencies to reverse rapidly. Predictions of boom and bust can be complicated. One way may be observing terms of trade.
Looking at terms of trade for commodity nations such as Australia, New Zealand, South Africa, Canada and Brazil may serve as a predictor since these nations are dependent on exports for foreign exchange revenues. If exports are increasing to the United States, cycle beginnings may be occurring.
Yield curves always served as valuable predictors in the modern day of boom and bust economic activity especially the 10 year Treasury Bond and the shorter 3 month T-Bill. If the 10 year bond price falls below the 3 month T-Bill or if those prices are falling towards the 3 month T-Bill, recession is looming. When a formal cross occurs, recession is imminent. This would confirm the need for investors to seek higher yields by purchasing commodity futures.
Because commodity currencies have floating exchange rates, another predictor is to correlate exchange rates to commodity indices such as the Reuters/Jefferies CRB Index. The purpose to use Reuters/Jefferies is its not only the oldest of the other three that dates back to 1947 but its heavily favored towards physical commodities rather than metals. Physical commodities will always react faster in any boom or bust cycle than metals such as gold, silver, platinum or Paladium.
Metals are laggard indicators. Yet a correlation of the S&P/ Goldman Sachs Index that began in 1970, Dow Jones/ AIG Commodity Index began in 1991 and the 1980 IMF Non Fuel Commodity Prices Index may also serve as predictors when measured against commodity currency exchange rates. A true correlation is needed. This model has been a predictor of future economic activity one quarter ahead.
Smarter market watchers will look at the Baltic Dry Index. This is a commodity in itself and trades on an exchange. The Baltic Dry Index not only determines how many ships leave ports loaded with commodities but they determine shipping rates. Lower shipping rates and few ships leaving ports for exports is a valuable indicator and early warning sign of boom and bust cycles.
Except for the yield curve example, all predictors focused on short term cycles. What drives short term demand for currencies and futures prices can’t be explained by larger macroeconomic models.
They predict long term rather than short term movements. Scholars, economists, traders and market watchers can’t agree when cycles began or ended.. They only know when we are in one or the other. This determination can only be found by looking at past economic data. But one variable can’t determine which cycle exists. Past years of research looked at employment as a predictor until they found employment was a lagging indicator. Others looked at such factors as the National Purchasing Managers Index and even compared that data to prices and economic activity within the 12 Federal Reserve Districts. This proved faulty. So inflation studies began. This again proved faulty so we looked at core inflation and then subtracted core inflation from food and energy to predict cycles. None proved absolute.
Modern day studies focus on the markets and market indices and compare technical analysis to fundamental analysis to determine if a valid prediction may exist. Much of the research is good and getting better but we still don’t have a definitive answer to when cycles began or end. Yet no study of micro or macroeconomic models can serve us properly unless we look at commodity supply and crop reports.Until an answer occurs, investors and traders would be best served watching the markets for direction.
November 2009 Brian Twomey
Brian Twomey is a currency trader and adjunct professor of Political Science at Gardner-Webb University.