By Miacael V Dunn
The sage American philosopher, baseball great Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” I think we all recognize that futures markets are notoriously difficult to predict and understand.
Maybe that’s why people are so suspicious whenever they see record prices in the futures markets, especially for commodities. As you all know, the prices for daily staples such as food and energy have risen to staggering levels, far above what anyone would have predicted just a few years ago.
These price increases are reaching into every corner of the global economy, and ordinary citizens everywhere are asking – no demanding - an explanation. And as you all know, some people simply don’t believe that these prices are justified. They suspect that something has gone wrong with the functioning of the commodity futures markets, and they want it fixed yesterday.
Fundamentals or Speculation or Both?
There are two sides to this debate. One side says that fundamentals such as the weakening of the dollar, tight supplies, and increasing demand sufficiently explain the price increases. The other says the increases are driven by a tidal wave of speculative trading by banks, hedge funds and institutional investors. And some say that it is a combination of these driving prices.
We know from the data we collect from our market surveillance that there has been an increase in speculative activity in our markets. But it is not clear, at least not to me, what impact this is having on prices. Based upon our staff’s surveillance and research, we can tell a pretty good story about why market fundamentals have been, at least partly, behind the price increases in agricultural and energy markets. But, it is undeniable that there have been large flows of new investment into our markets.
Commodities appear have become an asset class in their own right. More and more investors, both retail and institutional, are allocating part of their portfolios to investments that are tied to the performance of commodity futures. The performance has been good, especially compared to the more traditional asset classes. They add diversification to investment portfolios, and they provide a hedge against inflation.
The real question here is scale. Each one of these investments might be relatively small, but what happens when the trickle becomes a flood? Essentially, the argument goes, instead of pricing just supply and demand factors, commodity markets have begun to price commodities’ value as an asset class as well, creating a price distortion or possibly even a bubble.
So what is the answer? The answer is … we are not quite sure. Considering our current knowledge, I doubt it is possible to come up with a definitive answer one way or another at this time—markets and market behavior are simply too complex and our understanding is still evolving.
We continue to build upon our ongoing research, but, currently, I think decisions as to the role of speculators in futures markets reflect a good dose of professional judgment—the data cannot provide all the answers.
Bubble Policy
But let’s suppose we go to the next step. Suppose that we could all agree that, yes, there is too much speculation in the market. What would we do next?
This is actually a larger question about the proper role of regulators in all markets. As many of you may be aware, there is a tremendous debate among financial regulators about whether something should have been done to prevent the bubble in housing prices. While I am no expert on housing markets, I think some of the issues that are being raised in that debate are worth considering in the commodity futures context.
If we believe the federal government should have a role in deflating bubbles, a government regulator first would have to satisfy itself that bubbles or price distortions exist and that they have substantial, negative, economic consequences. Then the regulator would have to identify the causes of that bubble or distortion and construct a market intervention that would address the problem and return prices to a level reflecting a fundamental value.
Even given everything we know about futures markets, I think we need a certain amount of humility about our ability to do that, and do it correctly without causing undesired collateral economic damage.
There are no generally accepted models that yield answers to the causes or solutions of commodity bubbles. In fact, you can find examples in history where interventions commonly thought, at the time, to be “bubble popping” actually ended up making a bubble worse.
In the field of toxicology, one of the mantras is, “the dose makes the poison.” Since virtually every substance has the propensity to be toxic at some dosage, a great deal of the science of toxicology is trying to find that lethal dose.
