Commodity make or break time?

The U.S. markets face a busy week. The Federal Open Markets Committee begins its meeting on Tuesday and will most likely leave policy unchanged. Don’t forget that in addition to the short-term fed funds rate there is now an additional quantitative easing policy measure. The Fed’s purchase of about $1.7 trillion of mortgage and government bonds in the open markets has stabilized the housing market and runs out in March. Hence investors will be keen to hear within Wednesday’s statement what the Fed will do to either abstain beyond March or extend a new round of intervention. 

The U.S, treasury will also be auctioning $118 billion in fresh debt this week as the economic reparation measures continue to rack up the budget deficit. On Friday the first glimpse of fourth quarter GDP will arrive and given the snapback it will be no surprise to see a jump in activity. The obvious question is whether such momentum can be sustained. On Tuesday we’ll find out whether or not consumers carried over rising confidence into the New Year.

And of course on Tuesday President Obama delivers his State of the Union address at a time when the going on Capitol Hill is getting tougher by the day. The markets gave a universal thumbs-down last week to plans announced on Thursday to rein in the value of risky positions that banks can take and analysts were far from short of ammunition when it came to returning the arrow fired by the President.

The issue of implementing rules on commercial and investment banks may have serious implications for banks. But if you look at the markets’ reaction last week you’d conclude that the end of the world was nigh. The major stock market indices ended a three-day bobsled run at maximum velocity on Friday as stocks torpedoed through the finish line looking like no snow wall would be big enough to contain the rocket in momentum.

Here’s what’s at the heart of the issue: Big banks use part of their capital to take positions in other asset classes. Often this can come from within the value of deposits held by the bank. Because many of the asset classes deal in leveraged investments where margin is employed, the value at risk can be substantial and in effect can be greater than the money borrowed by the bank to take a position in the first place.

The worst case scenario is of course that markets come crashing down and everyone gets burned. And it’s not true to say that markets can only crash to the downside. A lot of money was lost when crude oil futures accelerated towards $150 per barrel in June 2008. Investors continued to pick a top to that markets time after time and much of the last part of the exhausting ascent was shorts struggling to find anyone brave enough to sell and allow them to take a loss. Typically, the worst case is irrelevant since as was proven when Long Term Capital Management was wrecked in 1998, the blow up of a single institution – no matter how important it is at the time – is a manageable event that management can be blamed for.

The real problem comes, as we saw, when everyone is doing the same thing in the belief that they’d be stupid not to precisely because everyone else is. Being leveraged up to the hilt on other people’s money is a sure-fire thing 99% of the time, but Wall Street is now arguing that you can have your cake and eat it too.

The outpouring of investor irritation on Friday manifested itself in a waterfall of selling pressure as investors took advantage of the most liquid markets where they believe speculative investors will have no chance but to quit if the Obama plan passes through Congress.

Sugar prices fell by the most in two weeks having earlier reached a 29-year peak and gold prices fell to a one month low. The Reuters/Jefferies CRB Index of 19 raw materials touched a four-week low, and financial equities fell. Sugar prices have doubled in the past year on concerns over problems facing the fundamental supply situation as adverse weather in Brazil and India, the world’s largest producers. Meanwhile a rising demand picture has caused a spike in pries. Despite being a major global producer, India has become a net importer of sugar but has to compete with demand from Pakistan, Egypt, the Philippines and Indonesia.

Sugar is just one example where there are clear issues on both sides of the fence, yet the threat of clipped wings to major players created a new major factor last week. One of those major players, JPMorgan Chase last week said that the proposal might deprive the largest banks from $4.67 billion in revenues after investors and speculators poured $60 billion into commodities raw materials in 2009. This week promises to be make or break for commodity prices.

John Bull
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