The wobbles in commodity markets in recent weeks may well be related to the imminent end of the US Federal Reserve’s $US600 billion QE2 quantitative easing program. With Ben Bernanke declining to rule out a QE3 program when QE2 is completed at the end of the month the markets are trading in something of an information vacuum.

While Bernanke himself, in a speech to the IMF this week, tried to play down the relationship between the QE2 program and the dramatic run up in commodity prices since the program started about nine months ago, there is little dispute within the markets themselves that the massive infusions of liquidity and their impact on US rates and the dollar have ignited massive levels of speculative activity in commodities and emerging market bonds and currencies.

Hedge funds and others have piled into carry trades that involve shorting the US dollar and taking leveraged exposures in commodities — and the Australian dollar.

While there is no doubt that there is a fundamental element to the soaring prices of commodities and the strength of the Australian dollar — Asia economic growth and the tightness of the supply-demand equation for the resources needed to fuel it are fundamental influences on the commodities markets — commodity markets have exhibited bubble-like characteristics as this year has progressed.

The significant sell-off that has occurred in those markets over the past month would tend to support the view that there has been a significant component of financial speculation within commodity prices that has started to unwind as investors became nervous about the implications of the end of the QE2 program.

It is, of course, rational that there have been significant levels of speculative activity in response to QE2. The program was designed to encourage support for riskier asset classes by driving down the rates on US government-issued securities and it has worked to provide support for equity markets and, by driving down the value of the US dollar, support for the competitiveness and profitability of US exporters.

With uncertainty about a continuation of the program — Bernanke hasn’t ruled QE3 either in or completely out — it is also no surprise that markets have become more volatile as the end of the current program nears.

With the US economy remaining weak and at some risk of a double-dip recession, the Fed will be torn between the desire to withdraw stimulus and allow us rates to drift up rather than encourage even riskier behaviours and the risk of forcing the economy into reverse again.

Complicating the situation is the failure of the OPEC members to agree an increase in production targets in Vienna overnight, which had an immediate impact on oil prices. Another spike in oil prices would be chilling for economic activity in the US, Europe and Japan and could force the hands of the central bankers.

It is no bad thing that some of the “froth”, as Glencore’s Ivan Glasenberg recently described it, is blown out of commodity markets. Bubbles created by speculative activity distort and destabilise markets and real economies and can have very unpleasant impacts when they burst.

Until the future course of US monetary policy is clearer, and its impacts seen, however, it is probable that commodity and currency markets will remain quite volatile and dangerous.

*This article first appeared at Business Spectator

Peter Fray

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