Monday, October 22, 2012

2015: Commodity Price Collapse, US Treasury Rates and Bursting the Gold Bubble

Overshoot, Overestimate, Overdistribute, Overhang

Michael Pettis' in his recent article By 2015 hard commodity prices will have collapsed argues that hard commodities - mainly iron and copper - will have hit a price bottom by 2015.  Large mining projects in Australia have lead to and overshoot in demand estimates and speculative purchases have lead to swelling surplus stocks of hard commodities in China; slowing demand for commodities in China and a Chinese economic rebalancing (slow down in the number and scale of construction projects) threaten to cause a price bottom by 2015 according to Pettis.  From the article:

There are four reasons why I expect prices to drop a lot more. First, during the last decade commodity producers were caught by surprise by the surge in demand. Their belated response was to ramp up production dramatically, but since there is a long lead-time between intention and supply, for the next several years we will continue to experience rapid growth in supply. As an aside, in my many talks to different groups of investors and boards of directors it has been my impression that commodity producers have been the slowest at understanding the full implications of a Chinese rebalancing, and I would suggest that in many cases they still have not caught on.
Second, almost all the increase in demand in the past twenty years, which in practice occurred mostly in the past decade, can be explained as the consequence of the incredibly unbalanced growth process in China. But as even the most exuberant of China bulls now recognize, China’s economic growth is slowing and I expect it to decline a lot more in the next few years.
Third, and more importantly, as China’s economy rebalances towards a much more sustainable form of growth, this will automatically make Chinese growth much less commodity intensive. It doesn’t matter whether you agree or disagree with my expectations of further economic slowing. Even if China is miraculously able to regain growth rates of 10-11% annually, a rebalancing economy will demand much less in the way of hard commodities.
And fourth, surging Chinese hard commodity purchases in the past few years supplied not just growing domestic needs but also rapidly growing inventory. The result is that inventory levels in China are much too high to support what growth in demand there will be over the next few years, and I expect Chinese in some cases to be net sellers, not net buyers, of a number of commodities.
Aside from the articles cited by Pettis, there is one other peculiar news story corroborating his prediction: Caterpillar's 2015 outlook downgrade.
Caterpillar said profit will be $12 to $18 a share, compared with previous projections of $15 to $20. While a global recession remains possible, Caterpillar is forecasting moderate and “anemic” growth through 2015, Chairman and Chief Executive Officer Doug Oberhelman said yesterday in a presentation to analysts at the MINExpo industry conference in Las Vegas. Construction activity in emerging markets will probably show modest improvements, he said.
“We’ve seen a slowing in economic growth that was more than we expected,” he said. “We think ’13 could look like 2012 in terms of worldwide economic growth.”
Oberhelman has bet on a continuation of growth in commodity demand by buying mining-equipment maker Bucyrus International Inc. for $8.6 billion last year and agreeing in November to acquire ERA Mining Machinery Ltd. in China. His plans are coming under pressure as mining companies cut capital expendituresafter economic expansion slowed in China, the world’s largest user of coal and metals.
In other words, Caterpillar is betting on possible "anemic" growth and hoping for moderate growth.
Musings on the Overhang
Pettis elaborates that Chinese firms with large commodity stockpiles have fared better than their counterparts who do not maintain such large stockpiles.  The reason being, that as commodity prices increase so to does the value of the stockpile.  These firms are able to borrow against the increasing value of their commodity stockpiles.
A similar practice is used by home owners to refinance their mortgage.  For instance, a $100,000 mortgage on a home worth $100,000 can be refinanced when the home value rises.  This can be done so long as the home's value continues to rise.  What happens when it doesn't?  Short-sale?  Default?  Pain?
There are a few financial outcomes for Chinese firms as their commodity stockpiles' value begins to decline.  How these firms (and the broader Chinese economy) manage to deal with these declining commodity prices will be worth keeping an eye on.  Initial actions may include a kind of stockpile liquidation sale which could cause further downward pressure on commodity prices.
Chinese GDP Growth Rate Falls Below 5-Year Plan
Chinese GDP growth figures for the latest quarter were below 5-year plan estimates.  Not to be discouraged, Premier Wen Jiabao has called the news "relatively good".  It should be taken as relatively good news that the Chinese politburo has come around to acknowledging their nation's economic slowdown, to some degree.  China has a large export based economy and their largest trading partners, the European Union and the US, have experienced declines in aggregate demand.  Inevitably China was due to experience a post-recession slowdown in its own economy.
2015: The Finish Line or Start Line?
Pettis' 2015 date is rather interesting.  By 2015, US treasury rates should begin to rise (or at least stop declining in some cases).  That at least was the implicit promise by the Federal Reserve after announcing QE 3.0, which by then hopefully will have concluded (with a possible $2 trillion worth of MBS (mortgage-back securities) on their books).

MBS Held by Federal Reserve. Rough projection to the end of QE 3.0 at the end of 1Q 2015 - totaling $2 trillion.

If interest rates do rise, look for the gold bubble to deflate.  According to Henry C. K. Liu:

If gold is the measuring monetary metal, when gold prices rise against the dollar, or other dollar-linked currencies, the holder of gold has not become richer, he/she has only protected him/herself against inflation. However, money generates interest payments, and gold does not, unless it is leased, then it ceases to be a monetary metal. Most of the comfort of holding gold is psychological. With US treasuries paying next to nothing and some 3% behind inflation, gold is an instrument of no penalty. But interest rate will rise which puts pressure on gold.

Adjustable-rate mortgages are usually indexed to the 1-year Constant Maturity Rate or its lock-step cousin LIBOR.  By the time the Federal Reserve increases interest rates, it will probably have $2 trillion of the worst MBS on their books.  Which I think is when they expect the next housing boom (bubble) to begin - which defies the inverse relation between asset (security) price and interest rates the Fed will start imposing.  However, the housing boom and the increase in treasury rates (especially short-term rates which could end the Treasury's current carry trade) should begin to deflate the gold bubble.

Expansion and contraction of long-term and short-term US treasury rates. Many short-term interest rates have been held at their lowest levels for the past 3 years and may stay low for another 2-3 years.

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