Tuesday, November 17, 2009

Business cycles, industrial production, and commodity prices

Commodity prices move with the business cycle. The relationship is different than what you find with equities and bonds. Commodity prices will usually peak later in the cycle. The relationship in more real time can be viewed through moves in industrial production. When production fell, commodities hit the skids. There has been a turn-around in production but we are still below levels from a few years ago, yet commodity prices have stayed much higher. Put differently, the price levels for commodities suggest a higher level of global production.

Of course, commodity prices are less than what we saw during the peak in 2008, but they are generally higher than levels of a few years ago. This could be caused by one of two reasons, the demand or supply side. The supply side argument would be very simple, we are running out of everything and there are shortages. Not likely The demand side is that investors want to hold commodities in this environment. It could be inventory restocking, or the desire to hold hard assets over financial assets. This may make more sense when the supply of money around the globe has exploded. This is not a bubble, but a rational response to the changes in supply of financial versus hard assets.

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