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Why Commodities Are Soaring

The rise of commodities is confounding traders and economists alike. If you look at a chart of the CRB, it becomes blatantly clear that we are experiencing a dramatic move upwards:

Click here: $CRB - SharpCharts Workbench - StockCharts.com

This contradicts all the negative reports indicating a dramatically slowing economy. The CRB says we are experiencing straight-up commodity inflation. It's predicting greater commodity demand ahead. My forecast of a nasty first quarter followed by an upswing the rest of the year is looking more and more feasible.

In my January 9th article Why I've Turned Bullish On Gold, from Seeking Alpha, I wrote:

"Either way, with or without a slowdown and some possible nasty problems in the first quarter, I think the days of disinflation and actual deflation are numbered. Whether sooner or later, I see growth higher from here after years of stagnation, gaining momentum in the second half of the year, and building momentum from there.

"It's for this reason that I am predicting a turn in gold, silver, and most commodity prices in 2014.

"Where gold has been discounting disinflation and possible deflation since October of 2011 and has been falling, I think it will begin to discount 2 to 4% inflation rates over the next year or two. Whether through a return to easier money by the Fed to prevent deflation, or just plain higher world growth and demand for commodities as inflation finally moves higher rather than lower, I think 2014 will be a year of higher commodity prices. Once inflation stops falling, the discounting process of falling commodities will also end. Instead of commodities discounting weakening world demand, they will begin discounting strengthening world demand, and higher prices will result.

"The CRB, which fell from 370 in 2011 to a recent low of near 270 should bounce above the 300 level at the minimum and run higher. Gold and silver should put in a similar performance. If both GDP and inflation rise or are even firm from here, gold should move up, and we should see higher demand for resources and resource stocks in general.

"And that I think will be the trade of the year."

The following quote, by one of my favorite commodity traders, sums up the confusion that traders are feeling when it comes to these markets.

"For some reason, commodities in general have been soaring recently. Shorts are getting obliterated across the entire sector with a vengeance. You name it - coffee, sugar, hogs, soybeans, wheat, corn, silver and of course gold. Frankly I am unclear as to what the main driver is for this sudden interest in the commodity sector."

It has caught almost everyone by surprise. Remember only two months ago everyone was as bearish on commodities as can be imagined. No one would touch them and predictions of further price declines into 2014 were commonplace. Remember the inevitability of $1100 gold, $1000 gold -- $700 dollar gold?

Why have gold and commodities turned on a dime?

The answer is a turn from deflationary expectations to inflationary expectations. In light of the Fed's tapering decision, this doesn't make a lot of sense to most observers and traders since a contraction in the amount of money being supplied should lead to higher interest rates, lower corporate earnings and lower stock prices, and it should lead to falling commodity prices. Yet just the opposite has been happening.

If you follow the money supply in circulation you will see a cause and effect as the percentage increase of money supply stopped falling at the end of last year and has been rising ever since.

The money supply as defined by M2, moved from a +10.55% pace at the first of the year in 2012 to a 4.73 increase at the end of the year in 2013. This amounted to a halving of the increase over a two year period of time.

http://www.economagic.com/em-cgi/data.exe/fedstl/day-wm2ns@@pchg364d.

Since then, the money supply has increased back up to a 6.02% rate of growth. Money is beginning to circulate again -- not just here in America, but world-wide.

This trend is augmented by the data showing China stabilizing, Europe coming out of a two-year recession, and Japan inflating rather than deflating and actually growing for the first time in over two decades. When we combine these two trends of growth and inflation, a picture emerges of higher future demand for goods in 2014. Is it any wonder that commodity prices are sensing the change of trend and responding accordingly?

Let me conclude by saying that nothing is 'baked in the cake". But markets are telling us that the winds have changed. Growth is replacing recession, and inflation is replacing deflation. And that, my friends, is the big picture pushing up commodity prices. We will keep a close eye on this, and let's be aware that this move has been sudden and dramatic, and a correction could occur at any time.

Paul Nathan