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Is The Worst Over For Commodities? Check This Chart

This article is more than 8 years old.

 Investors sifting through commodity charts to figure out whether the worst is over for commodities probably have missed a chart that paints a bleak long-term picture for commodities -- a secular decline in capacity utilization, which dates back to the late 1970s.

What’s behind this trend? Unprecedented monetary easing and ultra-low interest rates for a prolonged period of time, in our opinion.

Monetary easing and lower interest rates are usually bullish for commodities. They are followed by higher capacity utilization, which fuels inflationary expectations, and higher commodity prices.In a world of conventional economics, that is, where monetary policy is launched in a “normal” interest rate environment, and capital markets determine asset allocation.

But the world we live in is not conventional. It is a fantasyland where several rounds of conventional and non-conventional monetary easing have resulted in an ultra-low low interest rate environment in which central banks determine asset allocation. That's especially the case since the Great Recession.

In this world, new rounds of monetary policy are bearish for commodities. They are followed by lower levels of capacity utilization, which depress commodity prices.

ETF 12-month price change
iPath  Bloomberg  Copper (NYSE:JJC) -30.50%
United States Oil Fund (NYSE:USO) -61.80
SPDR Gold Shares (NYSE:GLD) -10.35

Source: Finance.yahoo.com


Here is how it works.

On the supply side, new rounds of monetary easing encourage producers to add capacity, as the lower rates stimulate investment.

On the demand side of the economy, things are a little bit more complicated. First, ultra low interest rates alter consumer math. They nullify the cost of financing purchases, and therefore equalize the cost of future consumption with that of present consumption.

Then, they change consumer behavior — prompting consumers to shift future consumption to the present.

Why wait to purchase that new car or those new home appliances next year, when the cost of financing the purchase is zero?

Now, think how the balance between the supply and the demand side of the economy unfold over time.

In the beginning, the lower interest rates get the more consumers shift future consumption to the present, narrowing the gap between supply and demand. That’s increased capacity utilization.

Eventually, lower interest rates have little impact on consumer spending, as consumers have already made their purchases, broadening the gap between supply and demand. That’s decreased capacity utilization.

Simply put, one can place secular decline in capacity utilization at the doorstep of the Federal Reserve.

As long as the Federal Reserve keeps interest rates low, the secular trend in capacity utilization will head south. That’s bad news for commodity investors.

To be fair, US capacity utilization isn’t the only factor that effects commodity prices.  So does capacity utilization in EU and Japan -- and most notably China, the factory of the world.

But the US is by far the largest consumer market in the world, which keeps these factories running.

That’s why investors should keep an eye on the American consumer to get a clue whether this bearish trend for commodities will come to an end, and whether the worst will soon be over for commodities.