Deflation in Commodities and Managed Futures Plus an Updated Hyperinflation Forecast

by Victor Sperandeo with the Curmudgeon

Introduction:

In last week's Curmudgeon post, we wrote about deflation in Europe. We still wonder why a small price increase (e.g. 0.3% year over year in August) is considered to be deflation by the ECB and other central banks. On Friday, the Economic Cycle Research Institute (ECRI) reported that inflation pressures in the euro zone have risen to a 28-month high. The Eurozone Future Inflation Gauge (EZFIG) rose to 97.4 in July from 96.6 in June. That suggests prices may rise faster than in recent months.

The real deflation has been in commodities and managed futures, which we address in this article along with an up to date hyperinflation forecast from ShadowStats' John Williams.

Background:

On August 26, 2010 at Jackson Hole, WY, Ben Bernanke (Chairman of the Federal Reserve Board at that time) proposed another round of creating money out of thin air by buying existing U.S. Treasury Bonds and Mortgage Backed Securities.

That new round of Quantitative Easing-- known as QE2 -- started in November 2010. Its announcement triggered a huge rally in stocks and commodities.

From Bernanke's Jackson Hole speech on August 26, 2010 till April 29, 2011, the S&P 500 advanced by +30.8% (without dividends). During that same time period, the Dow Jones - UBS Commodity index was up +34.8%, and the S&P Commodity Trends Index (LSC¹), which trades on the NY stock Exchange (a Managed Futures Long/Short Strategy) was up +40.3%.

Note 1. For full disclosure the LSC Intellectual Property is owed by Alpha Financial Technologies LLC, a company in which I'm [Victor Sperandeo] the CEO).

Bonds went the other way during those eight months- long term yields rose and bond prices declined. The yield on the US 30 year T-bond went from 3.53% to 4.40%, which translated into a 9.8% drop in price.

[April 29, 2011 marked an interim stock market top and was just one month before the Fed's printing scheme was to end.]

The results noted above involved "the politics of the Fed" claiming credit for driving the equities markets up. Yet Bernanke would not admit to driving up commodities, as he stated that rise was based on "supply and demand." He also denied that printing money is inflationary. (See "Ben Bernanke explains that QE is not inflationary, just an asset swap").

After defending the positive side of QE (i.e. driving stock prices up), Bernanke denied the negative side -- creating inflation via a 4.53% annualized increase in CPI.

The newly created money to buy debt was intended to drive interest rates "down" to help the economy. But one month before QE2 was to end, interest rates went up, and stocks went down. From an April 29, 2011 high, the S&P 500 dropped -- 19.4% by October 3, 2011 low. Long term interest rates rose and prices declined. Thereby, $600 billion of Fed paper purchases went up in "monopoly money" smoke.

The end of QE2 debt monetization by the Fed also created tops in the Commodities and the Managed Futures business, whose down trends still exists today.

[The stock and bond markets firmed in October 2011 and began a strong advance in anticipation of "QE3," which was announced on September 13, 2012.The Fed announced it would buy $40 billion per month of U.S. government bonds and mortgage-backed securities. Additionally, the Federal Open Market Committee (FOMC) said it would likely maintain the federal funds rate near zero "at least through 2015." Three months later -- on December 12, 2012 -- the FOMC announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month. Financial markets celebrated and with few exceptions (e.g. the "taper tantrum" of 2013), haven't looked back.]

Commodities and Managed Futures in a Funk:

The bear market in commodities and managed futures were due to several critical factors. Most important was using Dodd Frank to change the rules to make it unappealing for institutions to buy commodities. Increased margin requirements instituted on the swaps drove the costs up, and new trading limits restricted the quantity that could be purchased by any one entity.

I believe that Senator Carl Levin (Democrat -Michigan) was the lead to progress this political cause. Mr. Levin didn’t like pension funds buying commodities to protect themselves from future effects of inflation, attributed to the Fed's QE programs and Zero Interest Rate Policy (ZIRP). Levin was concerned that the Bernanke Fed and others in power (including him) would be severely criticized if commodities were up strongly, as that would be a forewarning of future consumer inflation.

On July 7, 2009, Levin said:

"It is a relief to know that the Obama Administration does not plan to stand by silently while inflated crude oil prices top $70 per barrel despite ample oil supplies and low demand. Instead of simply watching another run up in energy prices, the Commodity Futures Trading Commission has launched a top-to-bottom review of its authority to use ‘position limits’ to clamp down on excessive speculation and ensure commodity prices reflect supply and demand rather than speculators gambling on market prices to turn a quick profit."

This concept of changing rules to effect economic policies has been given a blessing in progressive circles as "rule by regulation." These "Sicherheits-polizei" (Security Police in 1939 Germany) can make losers and winners at the wink of an eye. It has caused most of the big banks to want to sell their commodity businesses.

A WSJ article "Wall Street Rethinks Role in Commodities Trading" states:

""Banks once gorged on commodities trading, because they had the advantage of really cheap financing," said Sanford Bernstein analyst Brad Hintz. But now, higher capital requirements have squeezed profits out of the business. That is because the commodities business, like other trading desks, needs to borrow to do business."

The article goes on to say that "Regulators increasingly want banks to get out of risky businesses, and some are skeptical about the commodities business."

Not enough proof? A September 6-7, 2014 WSJ article "CFTC to Examine Swaps Loophole" states that "the Commodity Futures Trading Commission (CFTC) plans to scrutinize U.S. banks that are shifting some trading operations overseas to avoid tough CFTC rules. The agency also will work with other regulators to determine if the practice poses a risk to Wall Street."

It seems like all the government complaints are written to make it look like they are concerned with "the risk" to the U.S. Yet the CFTC says "the risk" is in offshore separate subsidiary companies???

It's rare to have a bear market last more than two years. Only twice since the 1800’s have the equity markets declined three years in a row (1929-1931 and 2000-2002). But commodities, using the DJ-UBS Commodity Index, have declined for over three years and eight months² with an annual negative return of -7.39% (compounded) during that time period.

Note 2. The actual annual returns were 2011: -13.37%, 2012: -1.14%, 2013: -9.58%, and 2014 (YTD): -4.55%.

The Managed Futures business has performed in a similar negative way, but a bit better ... By comparison, the Barclays CTA index in 2011: -3.09%, 2012: -1.71%, 2013: -1.41% and 2014 (as of June 30th): + 0.67%.

However, the Barclays index has fared much better than individual CTA's³ as these indexes are like Fund of Funds and include highly diversified long short strategies. There's also a positive survivorship bias built in, as the funds that close due to huge drawdowns are dropped from the index.

Note 3. The Curmudgeon confirms that managed futures mutual funds and private funds/LPs have been down much more than the Barclays CTA Index. One of the LP funds he's owned since 2001 is in a severe drawdown in excess of 50% since its previous high NAV.

A July 26 2014 article in Barron's "Managed-Futures Funds' Misery Continues" (on line subscription required) notes that assets in Managed Futures funds total about $230 billion, or roughly 8% of the $2.8 trillion invested in hedge funds, according to HFR. Most of that money is in trend following funds.

Pat Welton, co-founder of Welton Investment attributes those funds' performance difficulties to the flood of liquidity by central banks around the world, which have resulted in miniscule interest rates and lower spreads, making it hard to find good trends to follow.

Indeed, almost all of these commodity trading products are highly correlated to GDP, short term interest rates (e.g. T-Bills), CPI or other measures of inflation. With all of the above so low, trends in commodities can't be sustained and trends in bonds and shorter term notes and bonds are non-existent.

In addition, the performance of China's economy has had problems in the last five years which has lowered commodity demand. Let's now look at China's stock market for clues to commodity demand.

China's Shanghai Composite Index topped out on August 7, 2009. It then entered a multi-year bear market which made its low on March 12, 2014. I believe China is now in a bull (stock) market, so commodities should get some relief as the fundamentals catch-up to the technicals for world's most populated country.

Yao Hua Ooi, a portfolio manager at the AQR Managed Futures Strategy fund believes trend following pays off in the long run. He wrote in a research paper: "trend-following has delivered strong positive returns and realized a low correlation to traditional asset classes each decade for more than a century."

Conclusions:

I think the U.S. government’s policy goal was to drastically lower demand for commodities, while stimulating stocks to move higher. A hands off approach would've interfered with the Fed's QE and ZIRP policies.

This is the problem of all that's going wrong in the U.S. today…manipulation of whatever gets in the way of the federal government's desire! The goal is the power to execute the ideology of those in control. The results to "the people" are not important, as the singular objective is to get a new law/rule passed and executed. (See Obamacare for an example).

The winners are: real estate (especially housing), stocks (and "investors"), autos, greens, unions, etc. The losers include: coal, energy, tanning salons, commodities, managed futures, small business, cigar manufacturers and many others.

The end game is commodities will someday reach an out of balance supply versus demand situation. The illiquidity the government has created (by restricting supply and curtailing demand) will likely cause very strong gains. Managed Futures are profitable when there are trends that are strong and long-lasting.

The key is timing of the commodity supply/demand imbalance and trends that endure. It may take new elected government officials. The behind the scenes agenda of our government is that nothing is done without a political reason to obtain power and control. That's prevented free markets from functioning properly. Perhaps, all that will change after the U.S. midterm elections in November?

Hyperinflation Forecast from John Williams of ShadowStats:

"Extreme fundamentals against the dollar have been in place for some time, and they continue to deteriorate. Day-to-day timing on this is not possible much in advance. The circumstance likely will explode with little or no further warning, any time, triggered by any number of potential shocks to the consensus outlook, and very possibly--likely--by year-end."

The comment above on hyperinflation is current, but not an update; I have said and the same thing in my Commentaries to subscribers.

The hyperinflation report has been made available to the public (no longer subscriber only). The latest hyperinflation report was published on April 9, 2014.

The Second Installment--subtitled Great Economic Tumble--is designed to be read in conjunction with the First Installment. The update focuses on the nature of underlying U.S. economic activity and on possible preventative and hedging actions that individuals and the government can take versus the developing crisis.

End Note: The above opinions are those of John Williams, and may not necessarily agree with those of Victor Sperandeo or the Curmudgeon.

Till next time......

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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