Steep fall in commodity prices is providing the necessary global liquidity balance

Summary

• The steep fall in commodity prices impacted the global liquidity balance positively; the impact of monetary policy stances by Central Banks came on top, albeit at a phase lag.
• Huge liquidity bonanza was experienced by the industries in automotive, aerospace or other household sectors due to sustained low commodity prices at the expense of the commodity sectors (the speculators were the ones badly hit with dwindling collateral).
• The hardening of interest rates is likely to change the course of liquidity faster as commodity prices is likely to change trajectory quickly as well

Much is talked about the Central Bank's (Fed in particular) role as the engines of global liquidity; current deluge in commodity prices have hardly been cited as the reason for being the provider of global liquidity balance!

Even the most erudite of the financial world, the Bank of International Settlements, missed to point out as one of the factors. Gita Gopinath, the Harvard Professor, missed it in her recent post in Project Syndicate, that the dollar’s strength is associated to the fall in commodity prices in no less uncertain terms.

The BIS Working Paper 402 brings out the nuances around three very distinct variables that influence global liquidity:

1. Monetary Policy Variables
2. Supply of Credit Flows
3. Demand of Credit flows

The interplay of these three causal factors weighs on global liquidity such has been the hypothesis of the paper. However the role played by commodity prices in this equation has been narrowly missed as one other very important factor influencing global liquidity.

In the charts provided in the paper, the Supply of Credit flows have steeply come down from the highs of the credit loosening cycle that ended in 2008 and is still well below the base line. The demand for credit on the other hand has fallen disproportionately and is at its Nadir.

The ultra-loose monetary policy therefore plays the role of the supporting actor in providing the necessary fillip to ensure that we have some semblance of balance; but the balance is actually being provided by none other than the steep fall in the commodity prices, which is the one single broad element providing global liquidity.

The commodity prices are denominated almost 93% in dollar and with the strengthening of the dollar the liquidity impetus in dollars is even larger to the global system.

The key lever is oil and gas, which has provided more than $1.5 Trillion of liquidity support with the steep fall in prices, followed by a basket of ores and metals, including coal. The current sky-high stocks in all the asset classes mentioned above is frozen liquidity waiting to be further put on stream. With rising rates the reversing of liquidity buffers from these assets is likely to have medium to strong impact in the hedging activities conducted, which till recently has allowed producers to continue with their production even at ultra-low prices; with rising risks to these balance sheets, the intermediaries in trade would put limitations to the extent of hedging possibilities going forward due to lack of collaterals.

The biggest beneficiaries of this liquidity bonanza is the automotive, aerospace and household sector (almost an equivalent drawdown happened from the commodity coffers) which after a phase lag is now showing signs of demonstrated poise! The rising consumer surplus buoys markets of better sentiments to prevail.

This has nothing to do with Fed, or the EU Central bank continuing with easing.

If the supply glut is taken out in the commodities basket and prices harden, the global liquidity would need more than the usual monetary loosening initiatives that we have seen so far. Therefore the credit that we have passed on to the Central banks for providing an extended period of loose monetary policy should only be partial as the true influence of commodity prices never got its fair share of credit.

The expectation of rising inflation, in spite of low commodity prices, in some economies including U.S. in the recent times has been subdued, which prompted the Fed to keep the rates unchanged so far. That expectation is about to change and it is the first trigger for commodities also to change direction in terms of excess supplies. This changing dynamics in the coming months would be crucial to change the liquidity buffers of our current times.

My take is that interest rate change will prompt commodity producers to take out capacity faster than the past period as hedging options will be limited; this will prompt faster hardening of prices than we think. Given this back drop, it is more likely that the liquidity balance will change faster than we think.

The window for the speculators on the other hand just starts to look less hazy.