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DAVID KRUSE

By Staff | Oct 23, 2009

Everyone is bearish on the U.S. dollar, bullish on gold, expecting inflation to flare up and looking to buy commodities to avoid devaluing money.

So far, the only reason that gold has rallied and commodities have strengthened is because of speculators thinking that they will.

There is anticipation of inflation, but no actual underlying fundamental evidence of it. This speculation has been over done, seen as distorted. Government now sees speculation artificially raising prices as a problem and tighter regulatory pressure on investment funds is unfolding.

Speculators will be fighting City Hall to get around regulation. The German Deutsche Bank had gotten big into commodities, but has been ordered by regulators to reduce its CBOT positions by half. We have negative supply/demand fundamentals in many commodity markets yet those markets have gone up on inflation expectations.

These kind of detachments from fundamental reality create bubbles that can deflate quickly.

It wasn’t missed that there was snow and floods delaying harvest, but the primary focus of the CBOT last week was on inflation. Funds bought large amounts of grain/soy, predicated on the expectation of inflation. It is not fundamentally based. When speculators buy expecting inflation, in the short term it becomes a self-fulfilling prophecy.

The falling dollar and rising gold markets put the Fed in an awkward position. They can’t let it go on so may be forced to raise interest rates prematurely to an economic recovery.

Fed Chairman Ben Bernanke says that there is no fundamental basis for inflation today, but funds are trying to create one. World Central Banks pumped enormous liquidity into markets, but this liquidity has been soaked up. Inflation is too many dollars chasing too few goods.

There are plenty of goods relative to demand and plenty of excess production capacity to produce more goods.

It’s called “wage and price” inflation. Jobs, wage income and consumer credit and spending are still contracting. Commodity price inflation that raises consumer costs is of no benefit to the general economy. It does help commodity producers.

Last week’s run up in gold and drop in the dollar has to be alarming to the Fed. It will be interesting to see how it responds. Inflation is not growing from any grass roots demand for commodities in the U.S.

Speculative funds were criticized for taking commodity prices to surrealistic price levels in 2008. The funds are coming back now betting on inflation.

They are positioning in commodity markets for inflation. Washington doesn’t like speculators artificially inflating prices. They represent consumers and taxpayers and inflation is a tax on consumers.

Money going to pay for a rising cost of goods could be better spent deleveraging consumers or being invested. The powers that be are unlikely to let speculators run markets higher very long without any response.

One of these days, the skies will clear, the sun will come out, snow, if any, will melt and combines will roll. Harvest will resume.

What I think will happen is that farmers will be offered a good basis and good prices for crops this fall, but they will get caught up in the prospect of inflation and won’t sell.

Then the inflation anticipation bubble will burst and CBOT prices will fall precipitously again. The current rally in corn and soybeans is at best, half about harvest delays and the other half about speculation predicated on coming inflation.

When a farmer makes a decision whether to store or sell grain, he is essentially making a decision whether to store a hard asset or accept cash. One way to have it both ways would be for farmers to take the money selling grain at harvest and then buy a call option when markets weaken, risking only the premium of an option on a bet on inflation.

The Fed says that inflation is not currently at risk, but the general attitude of speculators today is that inflation is inevitable so they want to buy and hold commodities to be ready.

The CBOT rally concerns livestock producers who are losing money and will lose more if feed costs rise. I think that there is a huge disconnect between USDA feed consumption models and reality. The poultry industry continues to cut egg and chick sets. Beef feedlots have expanded placements again, which will bring more trouble with more losses.

The hog industry doesn’t have enough equity left to reach next spring when profits may be restored if herd liquidation is followed through with. The hog industry is being forced by lenders to find new collateral or modify production.

USDA, however, looks for feeding margins to improve and livestock feed consumption to expand in the October supply/demand report. They boosted feed consumption 169 million bushels from last year, plus absorbed the distillers grain produced as a by-product from 575 million bushels more corn crushed for ethanol, offsetting corn feed consumption. It would appear to be a huge bet on a robust consumer economic recovery in 2010 with a celebration of steak night’s out.

Livestock industries have lost so much equity that a period of profitability is needed before thoughts remotely return to expansion again. Nobody is making any money from feeding corn. The expansion from the ethanol industry forecast for 2010 is the final surge of corn consumption as the last new plants under construction come on line.

$4 corn has become what $5 corn was last year, the price at which nobody using it can make any money.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.

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