Commodity markets have long been the most volatile of financial markets, but have historically had little impact on worldwide monetary flows. That era has now passed. The spectacular rise in commodity prices has become a key driver of global exchange rate movements over the past two years, injecting tremendous uncertainty into the financial markets, and adding complexity to treasury operations worldwide.
In many ways, this rise in commodity prices can be traced back to the actions that governments and central banks took in the wake of the financial crisis. In a deliberate attempt to re-inflate asset prices in the real economy and kick-start investment, policymakers drove interest rates to 50-year lows, implemented spending programs on an unprecedented scale, and poured trillions of dollars in new liquidity into the financial system.
With cheap capital available in almost limitless quantities, and few attractive investment opportunities to be had, asset managers shifted a significant fraction of these funds into commodity markets in anticipation of an eventual recovery. Given the small size of these markets, these inflows had a substantial effect. When hedge funds directly control more than $2 trillion in assets, and a $100 million investment is sufficient to buy the entire outstanding interest in many commodity contracts, the potential imbalances are obvious.
Prices rose remarkably quickly. The International Monetary Fund’s Commodity Price Index doubled in the two years since the financial crisis. Fears are rising that the resulting increase in input costs will put the global economy on the slippery slope to another downturn.
Developed vs. Emerging Markets
The effect on developed world economies may not be as significant as is widely feared. The industrialized countries have sharply reduced their reliance on basic commodities in recent years, requiring fewer resources per unit of GDP growth than at any prior time in history. Production has become more efficient, and the share of the average household income that is devoted to energy and food costs has dropped steadily, meaning that commodities have lost much of their historical influence over spending patterns.
In contrast, emerging countries remain heavily reliant on basic foodstuffs, energy and building materials. While the impact on economic growth may be significant, it is the possibility of political unrest that represents the most significant risk for the currency markets. For the poor, these input costs can have a direct bearing on livelihoods—unhappiness generated by rising prices was an important driver behind the revolutionary movements which recently toppled regimes in Tunisia and Egypt. Alarmed governments elsewhere are taking steps to control prices, but it remains to be seen whether they will achieve success. Further political instability is highly likely.
The potential for commodity-driven currency market turmoil in the months ahead is high, as the world economy adjusts, and markets adjust with it. In spite of this, implied volatilities in the foreign exchange markets are relatively low. Currency risk is quite possibly underpriced, meaning that corporate hedgers may be faced with unusual opportunities.
Buying insurance when the house is already burning can be quite expensive. Buying insurance in advance makes good sense. It’s a simple idea, but simple ideas can have value in a complex world.
Karl Schamotta is Senior Market Strategist at Western Union Business Solutions.
This article originally appeared in the April issue of Risk.