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Red Hot Inflation Now Baked in the Crust As Investors Pile Into Commodities

Commodities / Inflation Oct 12, 2007 - 01:22 PM GMT

By: Adrian_Ash

Commodities

Best Financial Markets Analysis Article"...Wall Street and the City are suddenly piling into the commodity markets. Expect a side-order of '70s style inflation to hit your dinner table as a result..."

DIG OUT YOUR BELL-BOTTOMS and dust off your Doobie Brothers albums! This is where inflation stops hiding behind the official CPI data...and starts eating your cash savings and income alive.


"More fund investment in agricultural markets in 2008," says Lehman Brothers, now launching a "Pure Beta Index" to buy long-dated futures in 20 soft commodities...

"Funds' take-up of commodity indices to rise 20%," says the Financial Times , quoting Eric Kolts at Standard & Poor's. Global pension-fund investment in commodities will reach $160 billion, he believes, in 2008...

"Energy and commodities may avoid banks' job axe," adds the San Diego Union-Tribune , noting that "commodities and energy have been a massive push for everybody," as one investment bank analyst says.

"Banks will look to retain expansion plans in commodities, which is seen as a growth area," agrees a senior US executive...

Across the Pond here in London comes the Wessex Gold Fund, using leverage to go long/short of gold-mining equities and give itself "an additional edge versus long-only alternatives." That edge will cost anyone making the minimum $500,000 investment – with a minimum 12-month lock-up – some 1.5% in annual management fees, plus a 20% grab off any gains they might make...

Down under in Australia , Oceanic Asset Management is launching "a stable" of commodity investment funds at the start of November, looking to nab both retail and institutional money. It's starting with a $710 million equity fund based in London , plus an offshore hedge fund in the Caymans...

And UBS, meantime, just announced the launch of its Commodities Portfolio Algorithmic Strategy System. Nicknamed the UBS Comm-PASS, it's even more geeky than it sounds...running "a basket of strategies" on 19 different commodity futures, exposing its clients 51% to energy, and going both long/short yet again...

In short, "Burned subprime investors eye commodities for growth," as Reuters puts it. The impact on your cost of living should prove as dramatic as the bubble in global real estate they're now fleeing.

Investment-fund interest in commodities isn't new, of course; Merrill Lynch's World Mining fund, for instance, has grown nearly six times over since 2002. It grew another 18% last month alone.

But the urgency of this autumn's switch into commodities – driven by the flight from property and paper – is something else entirely. The PhDs who cooked up the US housing bubble are now applying their haute finance skills to gearing up the cost of natural resources.

Hence the complexity of the very latest commodity offerings. Expect a side-order of inflation to reach your dining table as a result very soon!

"The reality is that there are still few options for investors interested in gaining access to commodities through a fund," says John Fearon, director of Oceanic in Sydney . "The thirst for some exposure to commodities markets is growing all the time."

This sudden thirst for – and eager slaking of – schnapps-style commodity products begins, naturally enough, with the threat of inflation. Crude oil has more than quadrupled in barely five years. Wheat prices have doubled since April this year. Gold, that speechless seer of price-inflation ahead, has shot 15% higher in the last eight weeks alone.

That bodes ill for the value of cash in the bank and pay-packet.

"Other commodities are major industry inputs, [so] their relative prices change with the business cycle," found David Ranson of H.C.Wainwright & Co. in a study for the World Gold Council of Nov. 2005. "Gold is not subject to these distortions since it is not a major input to industry. Changes in the gold price are thus a good barometer of changes in currency values – and ultimately in the absolute level of prices."

Comparing gold with oil, for instance, between 1951 and 2005, Ranson found that gold's correlation with the Producer Price Index one year later was 0.37. Crude, on the other hand, managed a mere 0.01.

For Consumer Price Inflation 12 months hence, moves in the Gold Price averaged a 0.50 correlation, more than twice the correlation between oil and the CPI.

The current move in gold, leaping above $750 per ounce this week, was kick-started by the world's biggest central bank – the US Fed – cutting the price of Dollars borrowed by the world's biggest commercial banks. The Fed cut its "discount" rate by 0.5% on August 20th, back when gold was trading nearly $100 per ounce below current prices.

When unlimited money-supply growth crashes into rising demand for limited-supply essentials – such as natural gas, copper, soybeans and cocoa – the result is sure to be price inflation as violent as the monetary inflation that preceded it.

Add a sudden wall of money from Wall Street, the City, Frankfurt, Paris and Tokyo...all seeking a growth market to replace the can't-lose gamble of home-loan trading and credit...and the surge in basic resource prices will only accelerate.

Now add a little pixie dust...plus a dollop of leverage...and voila! One '70s-style inflation – or worse – cooked to order.

"There has been hedge fund interest" in cobalt, for instance, says Nick French – a cobalt dealer at SFP Metals in London – but not because the hedge funds foresee rising demand for hip replacements, loudspeaker magnets, jet turbine engines or any other of the metal's major end-uses.

Instead, "if you can push the price of cobalt up to $40 per pound from $20," says French, "then the share price of a cobalt mining company will double." Credit Suisse now offers a cobalt contract settled in cash, but backed by physical metal. But futures contracts, based – like everything else offered to investors by the high-finance industry – on credit, are only the start of it.

"An army of structured credit experts is studying products such as Collateralized Commodity Obligations – or CCOs," reports Reuters, "tied to the performance of a portfolio of underlying commodities, such as precious metals or energy prices.

In a CCO, "the issuer sells protection on the underlying commodity portfolio to the counterparty under what is known as a 'trigger swap agreement'. To fund its obligations under the swap, the issuer sells notes in the amount of the protection sold, according to Fitch Ratings. Proceeds from the notes then serve as collateral for the issuer's exposure under the swap until it matures.

"At maturity the issuer liquidates the remaining asset and returns the proceeds to noteholders."

With it so far? My guess is – and at least I'll confess it's just guesswork – is that the Reuters journalist and most likely the bulk of investors about to start buying CCOs have no idea quite what these products are, either. All they'll see, instead, is a steady stream of potential income. Provided, of course, that the CCOs pay-out at maturity.

Barclays Capital created the first CCO to be approved by the global ratings agencies back in 2004; in April this year, Credit Suisse issued $190 million in "triple-A" rated CCO debt, denominated in US Dollars, Euros and the Aussie.

"This product has opened up a new investment opportunity for investors who traditionally have not had exposure in commodities as an asset class," reckons Bikram Chaudhury of Credit Suisse's fixed-income desk.

In other words, bond managers and fixed-income traders whacked by the collapse of mortgage-backed debt can now put commodities into their portfolios – and just in time, too, for the runaway inflation about to hit thanks to monetary over-supply and heavily-geared financial buying. The magic of finance has turned consumable lumps of natural resources into a stream of income...without the bother of digging the earth or planting a crop.

But don't feel left out! The global finance industry is more than willing to help you gear up, too. Morningstar, for example – the US mutual-fund rating service – just launched a series of commodity indices applying basic momentum theory to go long or short when prices break the 12-month average.

"It cannot be long before exchange-traded securities will allow retail investors to take part in the action," says John Authers in the Financial Times.

Macquarie Bank in Australia, meantime, is now advising you delay making any commodity-stock purchases...lend your money to them on a "Hi Note" instead for 30, 90 or 180 days...earn a "high yield" in the meantime...but nominate now the purchase price you'll pay – of between 85-100% of the current share value – when the note matures.

High income, eh, with a cut-price mining-stock future thrown in for free? Sounds too good to be true, don't you think?

It may be worth recalling that when Refco, the US commodities and derivatives brokerage, went bust in late 2005, Jim Rogers' Raw Material Fund was owed more than $362 million according to court filings.

I'm not saying that any of the banks or brokerages now brainstorming clever new ways to gear up commodity profits are acting fraudulently or illegally today. Refco, on the other hand, was accused by Rogers of "brazenly violat[ing his] funds' instructions and deceitfully divert[ing] the funds' assets to an insolvent, unregulated entity."

But making the right call in commodities – and betting they're only set to rise from here – won't guarantee you turn a profit. Not if you rely on somebody else making the trades or making good on a credit-based promise.

Simply buy and sell the physical asset yourself, and at least any profits you make – and losses you suffer – will be yours to regret alone.

By Adrian Ash
BullionVault.com

Gold price chart, no delay | Free Report: 5 Myths of the Gold Market
City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2007

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

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