A new set of ties binds higher raw-material prices and bond yields—for now

AT FIRST glance, it has the hallmarks of a classic inflation scare. In the past week commodity prices—from oil to orange juice, silver to sugar—have reached eye-popping levels. In nominal terms, the prices of Brent crude, copper and zinc have hit record highs. Gold has topped $600 an ounce for the first time since 1980 and silver is at its dearest in a generation. Meanwhile, long-term nominal bond yields in America and elsewhere have risen to levels not seen in more than a year. On April 7th the yield on America's 30-year long bond climbed the 5% barrier, sending a flutter of fear through global markets. The ten-year yield may soon follow.

The rising costs of money and raw materials took leading roles in that economic horror movie, the 1970s, when inflation ran amok and growth froze. Once again, the two are connected, but in ways that are almost opposite to the ghastly stagflation of the past. If there is any common thread linking rising bond yields and commodity prices today it is not inflation, but growth—though there, too, the relationship is likely eventually to break down.
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The commodities boom began in 2003, as China sucked in materials from Middle Eastern oil to Chilean copper. The demand followed a long period of low investment by commodity producers, which exacerbated the sense of a squeeze. This had some curious consequences: in Britain, manhole covers were stolen, melted down and shipped east (tabloids called it “the great drain robbery”).

Meanwhile, despite healthy growth in the world economy, long-term interest rates seemed stuck. Alan Greenspan spent his last year at the Federal Reserve intrigued by the “conundrum” of why long-term bond yields weren't increasing, even as he and his colleagues were pushing up overnight rates to cool their economies. He left before the riddle could be solved.

Now an answer is emerging (see chart 1). Since the turn of the year, the yield on ten-year Treasuries has climbed to its highest level since the Fed started tightening in June 2004. The yield on ten-year German bunds is near a 17-month high. Japanese government bonds have been yielding more than at any time for nearly two years. But by historic standards yields are still low. And the component attributed to expected inflation, measured by subtracting inflation-linked yields from nominal yields, is even less threatening. It has barely budged this year. In America it hovers around 2.5%, in Europe just above 2% and in Japan below 1%—roughly where it has been for two years, even as oil and other commodities have gone ballistic.

There are plenty of reasons why hot commodity prices have not caused too many worries about inflation. One is that markets are confident that central banks will act to contain inflationary pressures. A second is that cheap Chinese exports have held down global prices. Another is that manufacturing's share of the world economy is declining; another is that the intensity with which industry uses raw materials is also shrinking—thinner steel in cars, for example—so that commodities' importance to inflation has diminished. And in real terms commodity prices are still well short of their 1970s peak (see chart 2). They have been on a downward trend since the 19th century, punctuated only by wars and other supply shocks: producers have generally coped with periods of surging demand, and probably will do so this time.

There is also a speculative side to the frothiness in the commodities market, which has grown since the rally started (see chart 3). As pension funds seek new sources of returns, some—such as the giant California Public Employees' Retirement System, with assets of $200 billion—are expected to dip their toes into commodities futures. In Britain J. Sainsbury, a supermarket chain, said it would choose commodities for about 5% of its fund, worth more than £3 billion ($5 billion) in all. Adding to the demand, the listing this year of exchange-traded funds in gold and other commodities has made life easier for would-be speculators. They don't even need to buy gold bars any more.

The cheapness of money has helped to feed investors' appetite for assets of all sorts—the ubiquitous “search for yield”. The rewards from investing in commodities have so far been extremely juicy.
Risks from the bond market

Now bond yields have at last begun to rise, sending returns for bond and commodity investors in opposite directions. The global economy is hot, which requires higher interest rates. To a certain extent, the rise in bond yields is a return to normality after the curious period when they failed to respond to tighter monetary conditions. This is no “debacle”, says Tim Bond, fixed-income strategist at Barclays Capital. “Things are safe and comfortable in the bond market at the moment.”

But whereas in the past higher commodity prices spelled bad news for bond markets, now the shoe may be on the other foot. Few expect that higher long-term interest rates will halt global economic growth, but they probably will have a dampening effect. That in turn should restrain demand for commodities.

Meanwhile, with yields rising, bonds will also compete with commodities for investors' funds, as they have with other risky assets, such as the Icelandic krona and the New Zealand dollar. With investors chasing commodities as if they were buried treasure, the danger is that returns will be even harder to find.

The bugs are back

High prices for gold, zinc, copper and other metals, and for other commodities like oil, are delighting producers. In London gold futures passed $600 a troy ounce and copper surpassed $6,000 a tonne on Wednesday. Prices are not approaching historic high points, but the various factors pushing them upwards—low stocks, a weak dollar, cyclical upturn, some fears of inflation, demand from growing economies, market sentiment—suggest the good days will remain for some time yet

AFTER some two decades of misery, it is only fair that gold bugs should enjoy themselves. Enthusiasts for the shiny, yellow, metal are delighted that gold futures passed $600 a troy ounce on Tuesday, April 11th, up by 16% so far this year. Adjusted for inflation, this price may still be nowhere near the highs producers once enjoyed. To match the peak, when the spot price hit $850 in 1980, gold would yet have to rise to about $2,200 in today’s money. But the bugs have excuse enough to cheer.

Much of the chatter surrounding the recent increase sounds eerily reminiscent of the gold rush last time round. The rediscovered popularity of gold coincides with low interest rates, particularly in America, and the gargantuan American current account deficit. These leave some worrying about inflation. Instability in the Middle East has increased the price of oil—itself an inflation factor—and made nervous investors think of fleeing into commodities, which seem safe and tangible in times of uncertainty. This week the price of a barrel of oil neared $70.
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The rising prices of gold and oil are part of a broader five-year run up in commodity values, which has been driven as much by optimism as fear. According to the International Monetary Fund, world output grew by 5.1% in 2004 and 4.3% in 2005. The latest IMF estimates are due later this week. Some predict equally rosy global performances are likely, perhaps around the 5% mark for this year and again for 2007. Much of that growth will take place in booming China, where robust demand is expected to keep up prices of oil and other commodities like copper which is a major component of, for example, electrical wire.

Producers are wary, of course. When prices slump, too much capacity can prove crippling. Both oil producers and miners recall painful lessons of previous decades when low prices were the norm. Many copper miners, for example, are so cautious that they still evaluate investments based on a price of 80-90 cents a pound, even though the metal is now trading at around $2.70, quadruple the price just five years ago. On Tuesday the price for copper futures passed $6,000 a tonne in London. Even those tempted to increase output now, to take advantage of the current boom, too rarely have the flexibility to do so on a large scale. Few producers leave mines (or oil wells) mothballed and ready to re-open on demand.

While much of the price growth is due to old-fashioned laws of supply and demand, there are less predictable factors too. One is market sentiment. Pension funds and other large investors now heavily favour commodities. The prices of lead, zinc, nickel, aluminium, gold and silver—which touched a new 23-year high of $13.01 an ounce on Tuesday—seem to be moving upwards in concert. That suggests fund buying may be behind some of the recent price increases.

According to the Financial Times, commodity funds now have $80 billion under management, up from a paltry $5 billion at the beginning of the decade. Some investors are using commodities as a hedge, to guard against a broad drop in the stock market. Commodity funds are also seen by some as a way to invest by proxy in China’s rapid growth. The worry is that if sentiment switches and the flood of money slows, the recent spectacular growth could be reversed.
High as a kite

That seems more likely in some markets than in others. Oil prices are expected to remain high for some time, thanks to Chinese growth and security threats in Nigeria, Latin America and the Middle East. Copper looks similarly tight. Inventories tracked by the London Mercantile Exchange suggest less than three days’ worth of global usage is in stock. This is a drop of more than 80% from 2003 levels, and production problems, most notably a bitter miners’ strike in Mexico, could mean inventories fall again. If prices keep rising, it may soon be worth melting down American pennies as scrap for their zinc and copper content—another echo from three decades ago, when speculators hoarded pennies, leaving shops and banks short of the coins.

And what about gold? Recent high prices seem linked to economic and political anxiety, and market mechanics, rather than soaring demand. It isn’t a crucial component of economic growth; its biggest industrial use by far is in the production of jewellery. And while gold may be a hedge against inflation, it is not clear that inflation is a really big worry. Tight monetary policy at the world’s biggest central banks suggests runaway inflation is unlikely to threaten the global economy any time soon. And yet, though sceptics have given warning over many months that gold is about to lose its glister, the price keeps rising. For now, at least, the gold bugs are having their day.