A Commodity Bull Market Coexisting With a Dollar Bull Market?

Posted by Donald Coxe - BMO Basis Points

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The shrewd Jim Rogers was once asked why anyone should buy gold when there was seemingly no inflation. He cited the current account and Treasury deficits and said, “Just do the math.”

As a general—and very useful—rule, the days the dollar is strong are days commodities and commodity stocks are weak. History shows that the greatest commodity bull market—the 1970s—was a time of severe dollar weakness, and the Triple Waterfall Crash of commodities came during a long, strong dollar bull market.

So, we are asked, can we have a commodity bull market coexisting with a dollar bull market?

In a word: Yes.

We have come to believe that this Odd Couple can coexist if investors conclude that bonds are no haven, and economic growth remains much stronger in the key Asian economies than in the US or Europe.


Because the 1970s commodity boom was an inflation-hedge boom. US inflation surged from 4% to 14% and there were three recessions within a decade. That commodities other than gold performed well was because investors learned that buying “out month” commodity futures was a hedge against inflation. Result: base metals piled up in storage because of inflation fears, while demand was erratic because of recessions.

We try to resist “New Era” thinking, but current conditions are collectively unique:

1. OECD government fiscal deficits totaling more than $4 trillion.

2. Government bailouts totaling more than $1 trillion.

3. Debt/GDP ratios at unheard-of levels—both government debt/GDP and total debt/GDP.

4. Global economic leadership now coming from China, India, Korea and Taiwan, not from the US and Europe.

5. Housing bear markets across much of the OECD with government housing price supports at unprecedented and unsustainable levels.

6. US State and local debt ratios at horrendous levels even before realistic costing of liabilities under employee pension and medical plans. We live in Illinois, which ranks just behind California for the scale of its unfunded employee pensions. A Stanford team recently costed out the unfunded portion of California’s state pensions at $500 billion—which is roughly seven times the total amount of state general obligation bonds outstanding. Illinois and California would need years of GDP growth at China’s rate to make their existing debts manageable—and many other states are in similar crises. One example of why the Canadian dollar is so strong relative to the greenback:

Everyone has always known that Social Security was headed for trouble, but we were told its cash flow wouldn’t turn negative until 2019; then 2016. It goes negative this year and that means the “fund” is evaporating quite rapidly. (Remember when the Democrats savaged Bush’s plans for Social Security savings accounts by telling frightened voters that Bush would be taking their money from its safe piggy bank where it was being kept for them? Great politics.)

The Social Security Trust Fund, which is a mere bookkeeping entry, “invests” in Treasurys at the approximate duration of the national debt. We appeared before the US Senate Finance Committee in 1988 to testify about what was wrong with the Fund. We criticized its investing strategy, pointing out that any private plan with long-term liabilities that invested in what was then a 7-year duration would be shut down. We argued the Fund should be getting the benefit of the high interest rates available on long Treasurys. Senator Moynihan called our testimony “powerful,’ but told me he couldn’t rally any votes for it because the Treasury was saving money by paying such low yields into the fund, and if Social Security invested in long bonds it would increase the reported fiscal deficit. Result: all those years of double-digit and high-yielding Treasurys came and went and Social Security only briefly prospered.

Compare that experience to the Canada Pension Plan, which for its early years (until the 1990s) invested in 20-year provincial government bonds whose blended real yields were high, then switched, as the bonds mature, to investing in market instruments managed by skilled professionals at the Canada Pension Plan Investment Board. The CPP isn’t fully-funded, but its market rate returns mean that its assets will keep growing for decades. Chile and Norway may be the only nations with better-financed public pension systems.

We conclude that the US will continue to look somewhat attractive compared to Europe, and so there will continue to be demand for Treasurys relative to bonds issued by European governments other than the leading countries.

The commodity bull market in this decade will be driven by (1) industrial demand for raw materials; (2) sustained demand for petroleum; (3) continued protein upgrades in diets in emerging and emergent economies, and (4) greater reliance on precious metals as stores of value—not necessarily as hedges against actual inflation. Inflation could in fact come with a rush if the global economy turns strong, government deficits stay high, and real yields on government bonds turn sharply negative. At the moment, measured inflation remains subdued because of heavy unemployment and large percentages of unused capacity across the OECD.

What is the difference between a store of value and an inflation hedge? Answer: a store of value at least maintains its market value under widely varying economic conditions and widely-varying or steadily-rising inflation; an inflation hedge is an asset boughtand held to produce big profits when inflation is high and rising—and investors think it’s going to rise even faster.

Gold ran from $38 to $850 when inflation ran from 5% to as high as 14%, but annual inflation during that period averaged in the high single digits. Once gold’s price was running far faster than inflation, it ceased to be a true store of value and became a speculative hedge—ultimately against inflation that Paul Volcker was about to terminate.


Published by:

Coxe Advisors LLP.
190 South LaSalle Street,  4th Floor   
Chicago, Illinois   USA  60603



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