All That Glitters The Hand That Rocks the Commodities

After a long stretch of almost uninterrupted gains for stocks, commodities and essentially every asset considered 'risky, but with an upside for significant returns'- markets have suddenly and inexplicably sagged.

So what's happening lately to the financial markets? After a long stretch of almost uninterrupted gains for stocks, commodities and essentially every asset considered "risky, but with an upside for significant returns" - markets have suddenly and inexplicably sagged. Without any clear economic turnabout or natural disaster in the background, prices began plummeting and thrashing about wildly these past two weeks.

Oil has dropped 10% this month, on some days fluctuating by as much as 3%. Silver, a glittering commodity for the last while, shed no less that one-third its value within 10 days. Shares also fell: U.S. and Tel Aviv stock market indices lost about 2% so far this month, and lo and behold - the dollar reversed its course, gaining 3% on the shekel and 5% against the euro.

All this wasn't supposed to happen. For months economists have been explaining that rising commodity and stock prices reflect bona-fide market forces generated by expanding economies around the globe, along with rising demand for the raw materials and finished products of publicly traded companies.

So is this a passing phase with markets shortly resuming their ascent, or will the volatility apparent in the last two weeks become the rule?

There are two schools of thought on the recent market fluctuations. The first claims that growth in the global economy is slackening, and declining demand for commodities presages the publication of data that will prove this. Proponents are quick to point to the price of the bellwether "Dr. Copper" - so named because of its tendency to foretell global trends due to its heavy use by industry: Indeed, the price of copper has fallen 15% since the beginning of the year. Economic data due to be published in the next two months will confirm or disprove this particular theory.

Monetary flows

The second school of thought centers around monetary flows. It says that many private and financial investors poured funds into commodity markets because of low interest rates and the U.S. Federal Reserve's monetary expansion policy, trying to earn any return possible. A large number of exchange-traded notes and investment instruments created over the past year in the commodities market have allowed small investors to wager on almost any good - the upshot being a price bubble which simply exploded.

This latter hypothesis has an advantage: It explains the sharp fluctuations in recent weeks that were caused, according to professional traders, by influxes and exits of speculative investors.

The extreme volatility has cowed industrial purchasers who have shied away from trading, the theory says, abandoning the arena to speculators, unprofessional investors, leveraged hedge funds, and automated trading program operators. And who profits? Why, the brokers, of course.

But events of the past two weeks have another explanation, this one political. As we wrote here last week, a pitched battle is being waged in the United States Congress over the Dodd-Frank Wall Street Reform and Consumer Protection Act that will curtail speculative proprietary trading by banks and brokers. According to a new version of the bill, restrictions will also now apply to financial trading in commodities, securities and, in fact, everything - save for currencies - that is presently exempt from new regulations.

Now the problem can be identified: If the middlemen are prohibited from holding large inventories and trading on their own behalf, the speculative side of many markets could be weakened and the inflow of money will shrink. But plenty of players will likely be trying to anticipate the knock-out blow, collecting their profits before the bottom drops out.

Why does this law have important implications? All the large trading companies in the energy field have united against it, worried it will hamper their use of derivative financial instruments and credit, burden them with new reporting requirements, and force them to put up billions of dollars in security. If the regulations are adopted, these firms threaten to pass the associated costs along to their customers.

The same objections and threats are heard from banks and investment houses, which are working hard trying to convince legislators to ease up. They want to ensure that loopholes, exemptions and certain legal measures will allow them room to continue operating in these markets, perhaps through foreign subsidiaries.

Bubbles and crashes

But all this isn't new. When a business sector so stridently opposes new legislation, especially regulations aimed at saving the country from price bubbles and future market crashes, clearly those regulations jeopardize an outstanding profit center.

In the U.S. this is a recurring story: Each time the financial industry identifies and develops a new market to fleece small investors, it invariably reaches bubble proportions and collapses. This happened with high-tech share offerings in 2000 and sub-prime mortgages in 2008. The same could happen to commodity prices in 2011 or shortly after, especially if the new law has a restrictive effect on banks, brokers and traders. As a general rule, any time a business sector objects to a new law it is worth checking out who wins, who loses - and how it affects the markets.