Ever since the modern-day economy emerged from World War II, predicting commodity cycles has been more art than science. Many economic variables have been tested for their correlative and predictive powers without a consensus over the years. Yet modern studies remain the best because time determines which variables hold up to academic rigor. Any study of commodity cycles can't find a foundation alone in a commodity nation such as Canada, New Zealand, South Africa and Australia because commodities are priced in U.S. dollars. So understanding periods of commodity boom and bust cycles must be grounded in the U.S. economy as a predictor of the future of declining economic activity.
Schumpeter and Cycles
The study of cycles is not a new phenomenon in the modern day. Joseph Schumpeter spent his life studying business cycles and published a classic work, The Theory of Economic Development (1982). Scholars, economists, market watchers and traders have since spent their time studying the factors: the variables that make cycles work, the booms and busts, and the tops and bottoms. We know cycles exist - but how do they work? What we learned economically since WWII is that not one factor or variable holds up to absolute rigor as a mechanism of prediction of boom and bust. So we will focus on various economic factors with the hope that two or three variables will correlate to understanding booms and busts and possibly predict the economic future. (For more, see War's Influence On Wall Street.)
Commodity Cycles and the U.S. Dollar
A significant commodity cycle occurred in the early 1970s and lasted until about 1980. Most would agree that Nixon's policy to take the U.S. off the gold standard was a major contributing factor that allowed such a long cycle to perpetuate. Since WWII, economies had never experienced such a long cycle. Historically, commodity cycles normally have durations of about 10 years. Gold, oil and physical commodities such as wheat, rice, corn and soybeans saw significant and sustained price increases during the 1970s cycle. What we learned from this experience and what we didn't know before because of free-floating exchange rates was the U.S. dollar factor. (To learn more, read America's Loss Is The Currency Market's Gain.)
Bust and Boom Cycles
During periods of U.S. dollar decline, commodity prices and commodity currencies typically rise. Because investors must seek higher yields, they do this by purchasing commodity futures. These factors can be attributed to interest rates. U.S. dollar declines are usually associated with interest rate decreases that presage a declining economy. During these periods, governments experience increased borrowing that leads to extended periods of the downward cycle. This allows the commodity cycle to continue unfettered while governments contemplate exit strategies from recessions.
Boom cycles are quite different. Boom cycles see credit expansions, rising interest rates and rising asset prices. But these boom periods are followed by reversals that normally have tendencies to reverse rapidly. Predictions of boom and bust can be complicated. One way may be observing terms of trade. (To learn more, see our CFA Level 1 Study Guide – Terms Of Trade.)
Other Commodity Cycle Predictors
Looking at terms of trade for commodity nations such as Australia, New Zealand, South Africa, Canada and Brazil may serve as a predictor because these nations are dependent on exports for foreign exchange revenues. If exports are increasing to the U.S., cycle beginnings may be occurring.
Yield curves have always served as valuable predictors in the modern day of boom and bust economic activity especially the 10-year Treasury Bond and the shorter three-month T-Bill. If the 10-year bond price falls below the three-month T-Bill or if those prices are falling towards the three-month T-Bill, recession is looming. When a formal cross occurs, recession is imminent. This would confirm the need for investors to seek higher yields by purchasing commodity futures.
Because commodity currencies have floating exchange rates, another predictor is to correlate exchange rates to commodity indexes such as the Reuters/Jefferies CRB Index. The Reuters/Jefferies is the oldest of the other three, dating back to 1947, and is heavily favored towards physical commodities rather than metals. Physical commodities will always react faster in any boom or bust cycle than metals such as gold, silver, platinum or palladium. Metals are laggard indicators. Yet a correlation of the S&P/ Goldman Sachs Index that began in 1970, Dow Jones/ AIG Commodity Index began in 1991 and the 1980 IMF Non Fuel Commodity Prices Index may also serve as predictors when measured against commodity currency exchange rates. A true correlation is needed. This model has been a predictor of future economic activity one quarter ahead. (For more, check out Commodities That Move The Markets.)
Smarter market watchers will look at the Baltic Dry Index. This is a commodity in itself and trades on an exchange. The Baltic Dry Index not only determines how many commodity-loaded ships leave port, but it also determines shipping rates. Lower shipping rates and fewer ships leaving ports for exports is a valuable indicator and early warning sign of boom and bust cycles.
Except for the yield curve example, all predictors focused on short term cycles. Macroeconomic models cannot explain what drives short-term demand for currencies and futures. They predict long-term rather than short-term movements. Scholars, economists, traders and market watchers can't agree when cycles begin or end; they only know when we are in one or the other. This determination can only be found by looking at past economic data.
Past years of research looked at employment as a predictor until they found employment was a lagging indicator. Others looked at such factors as the National Purchasing Managers Index and even compared that data to prices and economic activity within the 12 Federal Reserve Districts. This proved faulty. So inflation studies began. This again proved faulty so we looked at core inflation and then subtracted core inflation from food and energy to predict cycles. None proved to be absolute.
Modern day studies focus on the markets and market indexes and compare technical analysis to fundamental analysis to determine if a valid prediction may exist. Much of the research is good and is getting better, but we still don't have a definitive answer to when cycles begin or end. Yet no study of micro or macroeconomic models can serve us properly unless we look at commodity supply and crop reports. Until an answer occurs, investors and traders would be best served watching the markets for direction. (To learn more, see An Overview Of Commodities Trading.)