Components of Inflation: Commodity Pricing

[ForexArticles]

Forex traders can look to other markets to see what pressures are developing upon central banks. Pressure often comes from the pace of inflation moving outside of a comfortable range. One of the key components to find whether or not prices accelerating or decelerating at an above average clip is the pricing of commodities. If you can note which central banks are most defensive towards the deflationary environment or inflationary environment, you can look to broad trends in commodities to help build up a trade idea.

Why Commodities?

Commodities refer to energy, metal, and agricultural prices. As you can see, they are the components of which day-to-day life is built upon in the physical sense. Energy is responsible for powering the machines that grow in economy. Metal is responsible for construction of products big and large like skyscrapers or small and powerful like handheld computers. Agricultural prices determine how much food you’re leaving the grocery store with relative to the amount you have spent.

When these three commodities are combined, it’s known as a commodity index. The commodity index is much like the dollar index which is combined with the opposing trades of EURUSD, GBPUSD, AUDUSD, and USDJPY on an equally weighted basis. Over the last year, commodities have shown distinct weakness which leads many to believe from an intermarket point of view that the US dollar is moving higher and that global demand will move lower putting pressure on equities and struggling economies.

Commodities and Inflation

Because commodities make up the common core of a civilization, a rapid increase in overall prices of commodities without a follow-through in wage inflation could wreak havoc in an economy. History has provided multiple lessons where an economy grew too fast due to easy money policies similar to the ones the Federal Reserve had in September 2008 through today. These examples of rapidly rising interest rates and commodity price explosion is often matched with a headline photograph of a family standing in line for their basic survival needs in the form of commodities as soon as they are paid because they are afraid price will rise too much before next payday.

The easiest way for central banks to curb this rapid rising of prices is the raising of interest rates. Interest rates are a key component of currency strength or weakness within reason. Within reason means simply that a 15% inflation causing central bank rates be around 11% is not as ideal sized as a the economy with 2% inflation, the most widely accepted target inflation rate from G4 central banks, and a plan over the next three or four years to begin raising interest rates.

Understanding and Trading Commodity Pricing

When a number of commodity markets are showing signs of weakness, usually a stronger dollar or weaker demand is at play. Either of these scenarios is often unfavorable for a risk on scenario or a portfolio heavy in equities or stocks. You now know a trend of rising padded skit of key equities is on a display of a strong dollar or weaker demand so that the individual commodities.

Metals:

When looking at metals, gold is more emotional and silver is more applicable to construction. Given global growth, Asian-Pacific areas are often the greater consumers of metals but the country that often see the biggest benefit when metals are moving higher is Australia and its Australian dollar.

Energy:

When looking at energy, Brent or crude are often seen in the common tug-of-war of supply and demand balance. Over the last 10 years there have been drastic swings in both directions. Currently, we are dealing with an issue of oversupply relative to global demand. In summer of 2008, we were seeing a fear of oil running out’s in the near future as supplies from countries like China are only expected to accelerate. The common currencies correlated to energy are the Canadian Dollar, Norwegian Krone, and Mexican peso. Most energy markets have been relatively sideways for the last four or five months but a break of support given the stronger dollar and lack of demand we open up new levels of downside.

Happy Trading!