The Hightower Report

Below is an excerpt from The Hightower Report’s most recent Newsletter. To receive access to this story, with trade strategies, and our daily coverage of 16 markets, visit futures-research.com for your free 2 week trial!

As we enter 2011, there already appears to be a tendency to see inflation under every unturned stone. Last week, the markets saw what was labeled as a “hundred year rain event” in Australia, which launched a media frenzy of speculation that was primarily focused on coal, but at times the press attempted to extend the potential inflationary impact into the wheat and sugar markets. Just to highlight the ever-tightening linkage between commodity markets, some analysts suggested that a sustained disruption in coal exports from Australia to China could result in a shortage of power to Chinese factories, which in turn could derail the Chinese economy, which has become a very important cog in the machinery of the bull market in commodities. Other inflationary linkages have been noted in the markets over the last several months, as soaring cotton prices (to historically high levels) have prompted a huge spike in profits from wool, but the high price of cotton also has the potential to steal some acreage from the US soybean crop in 2011. In short, the markets in 2011 look to become even more intertwined, and that could point to even stronger volatility ahead.

While we count ourselves within the bull camp for most physical commodity markets in 2011, we have a special interest in what we call the “small” markets. We have expected physical demand for most commodities to continue to improve from the depths of the sub-prime recession, but we also think that investment demand for these assets will continue to expand. This might simply be too much for the smaller markets to handle without a significant appreciation in prices. As we see it, the key “small markets” for 2011 are platinum, palladium, oats, rice, coffee, orange juice, cocoa, milk and coffee.

We also think that markets like silver, bean oil, natural gas and sugar will behave like small markets because of the sharp ramping-up of physical and investment demand. In some cases this increase in physical and investment demand will be the result of alternative assets being historically high-priced, while in other cases it may result from a desire by investors to capitalize on the prospect of inflation.

Regulators are apparently poised to “take action” against speculation through new regulations that would tighten position limits, as they think that would curb the enthusiasm. Certainly speculation has increased prices for some commodities, but the key factor being missed by many “pundits” is that real demand is expanding and that so far higher prices don’t appear to have rationed demand. In fact, what the world is being presented with is an ever-lengthening string of adverse weather that has and will continue to crimp production. Therefore it doesn’t matter whether prices are artificially reduced or reduced for economic justification, reducing prices will have the impact of reducing production. And in the event that production is reduced, prices fall and the global recovery continues, there will be more acute shortages and even higher prices down the road. The American people wanted homes without equity, credit cards without jobs and health care for below-market costs, and now it appears that they want commodities to be cheaper than the cost of production! But the ultimate direction of commodity prices won’t be determined in Washington, Chicago or New York. Beijing, New Delhi, Sao Paulo and Moscow are the new market masters. When speculators are prevented from buying futures in a market facing long term shortages, look for the funds to “buy the cash!”

From a macroeconomic perspective, the odds of a significant, commodity-inspired inflationary spiral remain very strong. The odds of a “battle for acres” looms large in the US, and the US Federal Reserve has recently stated that they intend to continue to provide artificial support to the economy until it is on a track to repair its badly damaged employment situation. Even the Euro zone is seeing signs of inflation, despite a very suspect economy, and it’s only a matter of time before the EU is forced to implement either a bailout package or quantitative easing.

As for China, we can only suggest that the recent travails in Australian coal production areas looks to have contributed to even more inflationary pressures. However, because China can still be expected to battle against rising inflation and the US regulators look to quell investment in agriculture, the path to significantly higher commodity prices will be a rollercoaster affair.

Below is an excerpt from The Hightower Report’s most recent Newsletter. To receive access to this story, with trade strategies, and our daily coverage of 16 markets, visit futures-research.com for your free 2 week trial!

In the wake of a series of tightening moves by China over the past month, lingering Irish debt travails, persistent strength in the US Dollar and talk of new position limits in commodities, it would appear that the distinct upward movement in physical commodity markets from the June through early November time frame could be reversed “temporarily.” For the next two weeks, it is possible that further gains in the Dollar will result in a year-ending washout in commodity prices. But we don’t believe a washout will signal the end of the commodity rally, instead we think it will be setting the stage for an even bigger rally down the road.

While the resurgence of the Irish and EU debt crises are not something to discount out of hand, we think that a large portion of the Euro zone is in much better condition than it was when the Greek debt crisis surfaced. We also think that the Spanish and Irish economies will be more resilient that the Greek economy was. And we think that overall, global financial market anxieties are lower and that therefore the markets might not be as prone to whip the crisis back up into a full blown problem.

We are also not of the opinion that China is destined to kill their economy for the sake of restraining inflationary pressures, as many economists and traders seem to fear. Given the pace and quantity of Chinese physical commodity buying over the last two months, it would appear that China still sits upon a very sustainable pattern of growth. While some traders think that China’s buying pattern in 2010 was merely stockpiling or pulling demand forward, we think that the aggressive buying of grains and oilseeds might also have been part of the government’s attempt to quell inflationary pressures. According to recent press reports, the Chinese have been purchasing grain and food products that will be released this winter to head off rising price threats and/or regional food shortages.

With both Russia and China thought to be negotiating to buy as much as 4 million metric tonnes of corn from Argentina (Argentina’s total annual corn exports usually amount to only 17 to 18 million) and Mexico actually securing 120,000, it is clear that countries that haven’t typically imported grains are starting to do so. The 2011 crop year is shaping up to be battle for acres, but if the weather in South America becomes truly threatening, grain prices aren’t going to wait to see what shakes out in North America.

From a bigger picture perspective, energy prices managed two impressive rally attempts in the month of November, with the second one taking place directly in the face of a sharp rally in the Dollar. To us that suggests a very high probability of energy-inspired inflationary pressures ahead. In the meantime, it is possible that a rising Dollar will upend energy prices, even though a low refinery operating rate is already serving to tighten the product markets (see chart).

While the sharp rally in energy prices last week might have been the result of other developments, to us it seemed like a minor refinery glitch in California and news that Venezuelan refineries were operating at only 76% of capacity due to electrical issue were the main catalysts for the move. Perhaps the energy markets also found support off of talk of removing ethanol subsidies for budgetary purposes, as that in turn could threaten up to 6% of the US gasoline supply chain. Crude oil prices in the vicinity of $90.00 a barrel in the face of a sluggish global economy clearly suggests that some type of energy shortage remains in place, but the question will be whether or not Congress wants to make the shortage worse in 2011. RBOB trading above $2.20 might be a little expensive, but if the choppy pre-holiday period does bring about a break in energy prices, it should be viewed as a buying opportunity.

A number of unrelated physical commodity markets appear to have the capacity to extend their upward track, but it is our opinion that a temporary correction is needed before another wave begins in earnest. And while the markets might see a noted holiday break, traders and investors should be on the lookout for opportunities to get long some markets that are facing fundamentally tight supply situations.