Quantitative easing puts global commodity prices under strain

The US Federal Reserve announced in early November that it would inject a further US$600 billion into the US economy over the next eight months.

This monetary injection, in the form of quantitative easing (QE), might indirectly cause fluctuations in food commodity prices, for which international manufacturers should be prepared.

QE: An instrument to restore lending to the market

Quantitative easing is a monetary policy used by some central banks to increase the supply of money by increasing the excess reserves of the banking system, generally through the buying of the central government’s own bonds to stabilise or raise their prices and thereby lower long-term interest rates.

This is often considered a last resort to increase the money supply. The first step is for the bank to “borrow” from member bank reserve accounts, creating a depository liability. It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds, in a process known as “monetising the debt”.

More liquidity…to invest overseas?

The most immediate effect of QE is an increase in the liquidity of the overall financial system. Private banks and institutional investors may re-direct the cash received into lending to private businesses or individuals. Alternatively, they might decide to focus on acquiring assets in emerging markets.

In doing so, their profitability can improve in two ways. Firstly, they can tap into the revenue generated by fast growing industries in countries where both private and public consumption is expanding rapidly. Secondly, they can benefit from the predictable appreciation of local currencies in emerging economies – or rather the depreciation of the US dollar compared to other currencies.

Asian economies, particularly China, have reacted angrily to QE, accusing the Federal Reserve of artificially devaluing the US dollar in order to boost the US’ global competitiveness. Furthermore, the resulting increase in liquidity in overseas markets – as US institutional investors decide to divert part of their ‘new cash’ to emerging market assets – could cause significant distortions in recipient countries, namely in the form of inflation.

Interestingly, commodities – and not just food commodities – have traditionally been regarded as a safe haven in times of economic uncertainty and turbulent currency values. One key example is gold, which has seen its price increase by around 20% since the start of 2010. Similarly, food commodities such as wheat, corn, cocoa and soybeans, all of which have seen a steady escalation in their prices on commodity markets through the best part of 2010, could become key targets for investors seeking to maximise returns on their newly-acquired liquidity.

Outlook on past and future escalation in key food commodities

1) Russian fires heat up wheat prices

Global wheat prices have risen by 28% over the last year (November 2009-October 2010) and have been rising steadily since August 2010 when widespread wildfires in Russia prompted a self-imposed ban on wheat exports from the country.

The move sent shockwaves through global commodity markets, with traders fearing scarcity of supply and resulting in an immediate escalation in commodity prices. More recently, prices have increased still further due to poor prospects for 2010 wheat output in Canada, which is expected to be 25% lower than in 2009, according to agricultural crop specialists in the country. Current global wheat prices, however, are still around 40% lower than the peak reached in March 2008 when average FOB monthly prices exceeded US$439 per tonne.

Interestingly, the volatile state of energy and currency markets – alongside uncertainties in wheat output – is putting upward pressure on short-term trading in this commodity. Wheat futures contracts show a moderate upward trend with deliveries for March and May fetching a premium over December 2009 delivery prices of around 6% and 9%, respectively, according to CEM Group trading data as of 25 November 2010.

Wheat Futures (Cents/60lb bushels)

Source: CEM Group.

2) Demand for fresh meat in Asia underpins global rise in corn prices

Corn prices, which historically tend to be fairly stable, have not escaped the current food commodity inflation trend either. Monthly average prices rose by 37% over the November 2009-October 2010 period, according to United Nations FAO official statistics. As with soybeans, corn prices are steadily increasing as a result of strong demand for animal feed in countries like China.

This trend is, according to most industry sources, likely to continue on the back of stronger demand for milk and fresh meat in rapidly growing Asian economies. As seen with wheat, however, current corn commodity prices remain far lower (by some 18%) than their peak in June 2008.

That said, the latest research suggests that the pressure on corn prices has slowed in recent weeks and future trading data indicates stability in the short-term future. Corn futures contracts show a very mild upward trend, with deliveries for March and May fetching a premium over December delivery prices of around 3% and 4%, respectively, according to CEM Group trading data (25 November).

Corn Futures (Cents/56lb bushels)

Source: CEM Group.

3) Cocoa beans: The new gold?

Cocoa prices have recently jumped on the global commodity markets to levels not seen since the late 1970s, sending shockwaves throughout the cocoa processing industry. Prices for September- delivered cocoa reached £2,465 a tonne on 19 July 2010, the highest level for a second-month contract in 32 years.

The increase in cocoa bean prices is being fuelled by prospective economic recovery in emerging markets and short-term speculative movements in the futures market. Unlike in other commodities, average monthly cocoa prices in October 2010 (US$2,909 per tonne) are now at similar levels to the price hikes reached in mid-2008, according to IMF statistics.

Interestingly, while average cocoa prices in November have shown signs of slowing down, commodity futures contracts suggest a moderate rising trend. Cocoa futures contracts show a moderate upward trend, with deliveries for May fetching a premium over March delivery prices of 7%, according to CEM Group trading data (25 November).

Cocoa Futures (US$/tonne)

Source: CEM Group.

4) Staple prospects for global rice prices

Global rice prices have remained close to the US$500 per tonne mark since April 2010 and have seen little movement over the last eight months. Overall, global retail rice sales are projected to grow by 4.2% and 4.4% in 2010 and 2011, respectively, according to Euromonitor International’s estimates.

According to USDA estimates, rice production for the 2009/2010 crop will be slightly lower (down 2%) compared to the previous year. Rice stocks, however, will remain almost unchanged in relation to 2009, standing at around 90 million tonnes.

Rice prices show a fairly stable trend for the short-term future at least. The price of futures contracts for deliveries for March and May are fetching a premium over January delivery prices of around 1.6% and 3.4%, respectively, according to CEM Group trading data (25 November).

Rough Rice Futures (US$/cwt)

Source: CEM Group.

Future prospects

QE effects on major currencies remains to be seen

Regardless of media attention surrounding the US announcement of more quantitative easing, it is difficult to predict its exact effects on the currency market over the medium term. The pace and intensity of ‘printing money’ will be highly dependent on the US Federal Reserve, which will determine exactly how much money is pumped into the US economy over the next eight months.

As for the recipients of this cash injection, the use of extra liquidity might vary on a case-by-case basis. US banks and institutional investors might opt to keep the cash in the safe and use this extra liquidity to write off bad debts in their own balance books.

Alternatively, they could use it to partially increase lending within the US, which would in turn limit US dollar currency flows to emerging economies. Finally, they could just focus on hot assets in emerging economies to ensure potentially strong short-term returns.

Overall, the most likely scenario will be a combination of all three of these strategies: retain a part of the newly injected liquidity in their own balances and use the rest for increasing lending at home while also investing in international markets.

That said, and even in the case of a substantial amount of dollars flowing to emerging economies, the impact on any fluctuations in currency valuations is not 100% clear. The recent debt crisis in Ireland and current concerns centring on EU peripheral economies are affecting investor confidence in the EuroZone.

If EU-sponsored rescue packages fail to succeed in the short term, the weakening of the euro currency might well offset the effects of QE on the US dollar.

Interestingly, there are not many currency hegemon alternatives beyond the US dollar and the euro. Japan will soon embark on its own QE programme and China’s own fixed exchange rate for the yuan is unlikely to be significantly changed in the coming months. In addition, the impact of the US Federal Reserve announcement has not made a real impression on the market yet. In the futures currency market, for instance, the NYBOT US dollar index for March delivery contracts currently stands at 80.9 (25 November, Reuters).

This represents a 1.5% premium over the current spot index level (79.7), suggesting a slight appreciation of the US dollar against a basket of all major global currencies over the coming three months.

Best strategy for the future: Sustainable sourcing and geographical diversification

As for the implications of all this on food commodities specifically, it is necessary to differentiate two key factors. Firstly, uncertainty over fluctuating currency values is pushing investors – regardless of QE – to focus their speculative attention on more secure food commodities.

This is because demographic growth and increasing demand for staple food items such as meat, bread and milk in emerging markets is likely to push up real demand for these products – and thus commodity prices – in the coming years. The volume of investment in food commodities is therefore adding financial pressures on top of real price pressures, and could very well create a speculative bubble.

This is especially relevant in commodities with relatively low stock versus growth potential ratios like cocoa beans. In such cases, investors anticipate future price increases and add extra liquidity to already strained trading markets.

Fluctuations in the value of major currencies also affect food commodities in a different way. A QE-driven devaluation of the US dollar would make food commodity prices go up in nominal terms. At first, the impact of this increase would be felt more intensively in the US than in countries with stronger currencies.

Eventually, however, large-scale investment from newly US dollar-rich investors into emerging economies such as Brazil, Argentina, China or South Korea – all with stronger currencies – might result in inflation in the recipient countries. That would in turn increase the cost of food production in such countries and prompt a second wave of food commodity inflation at global level.

Strategically, large international companies whose activities rely heavily on food commodities should try and establish a sustainable sourcing strategy in the medium term. Manufacturers relying on short-term trading will be highly exposed to price hikes linked to ‘nervous trading’ – like that seen for wheat immediately after the recent wildfires in Russia.

Crucially, geographical diversification might also help international food manufacturers to offset price increases linked to the volatility of a particular currency.

Those failing to combine both strategies will likely be far more exposed to short-term price hikes that could, if increased in frequency, price them out of the market.