Sunday, May 30, 2010

Commodity prices and financial markets

One of the most interesting economic debates of the last few years has been that about the influence of financial market speculation on commodity prices. See here, here, here, here, and here. The sharp volatility in commodity prices, most spectacularly manifested in the case of oil, generated widespread scrutiny of activities in the commodities markets.

Economists like Paul Krugman pointed to the absence of any abnormal inventory build-up and backwardation (futures lower than spot prices) or weak contango (futures ruling higher than spot prices) in futures market prices, and rejected the speculation hypothesis and held the view that commodity price volatility was a reflection of underlying demand-supply conditions, especially in th emerging economies. However, others like Guillermo calvo and even the popular perception was that these price distortions were caused by the large investment flow to commodity indices - the total value of various commodity index-related instruments purchased by institutional investors increased from an estimated $15 billion in 2003 to at least $200 billion in mid-2008.

In this context, RTE points to a recent working paper, where Ke Tang and Wei Xiong have found that commodity prices have become increasingly co-related with one another and with stock prices. Examining the financialization process of commodities precipitated by the rapid growth of index investment to the commodities markets since the early 2000s, they write,

"We find that concurrent with the increasing presence of index investors, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with each other. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the Goldman Sachs Commodity Index (GSCI) and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed substantially to the large increase in commodity price volatility in 2008.

... while there was a small negative return correlation between the GSCI index... and the Morgan Stanley world equity index prior to the early 2000s, we find the emergence of an increasing trend in the correlation between the GSCI index return and the world equity index return, concurrent with the increasing presence of index investors in the commodities markets in recent years. There is also an intensifying trend in the negative correlation between the GSCI index return and the US dollar exchange rate in recent years. For individual commodities, we find that in recent years, their returns have become not only increasingly correlated with the world equity index and US exchange rate, but also with the oil return."

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