Drunk on the dollar? Time to throw up

In all these years of celebrating Deepavali/Diwali, I never seemed to get one thing right. I do put up the firecracker rocket facing straight up, snugly supported by some loose sand in a heavy bottle. But once I light it, the rocket gains a mind of its own. It never goes where I address it to-that is the blue yonder-but takes a turn in the most unexpected of directions and aims for a neighbour’s window or a parked car or even the backside of somebody I would be so embarrassed to alarm.

The US Federal Reserve does no better when it comes to monetary policy. The American dollar is the best lifting powder that there is but it never seems to go where the Fed wants it.

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In 2001, the legendary Alan Greenspan wanted to encourage companies deeply hurt by the bursting of the dot-com bubble to resume investing in their businesses. That was his recipe for reviving the US economy. He lowered interest rates and pumped money into the system. But the earlier sins of over investment kept companies from absorbing that cheap money. All the cash ended up in the hands of individuals fueling a housing and credit boom that ended in a way we will never forget.

Nearly a decade later, Ben Bernanke is facing exactly the opposite problem. The aspiring successor to Greenspan’s legacy let loose two rounds of monetary orgy, printing dollar bills by the tonnes and unleashing them on a deaden economy. He wanted consumers to take the money and spend their way out of the recession. But having lost their jobs and houses, families didn’t share Uncle Ben’s enthusiasm. So the orphaned money was ably adopted by speculators, investment banks and brokerages (aren’t they all the same?) that put the money in global commodities, US bonds, merger and acquisition deals and emerging markets equities to fuel new bubbles and a false sense of recovery.

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But why am I telling you this story now?

The commodity meltdown last week has made many investors sit up and contemplate the way forward. From silver to gold to wheat to oil, everything sank. The speed at which commodity prices have come down has surprised even veterans. Investment houses that had earlier put a target of $130 for a barrel of crude and $2,000 for gold have been selling their own long positions. Target downgrades have duly followed. While some speculators are keeping a straight face, no one really knows what will happen commodities now. A bloodbath is not entirely ruled out.

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If you are an investor in commodities, it is time sell out and run. Don’t look back at commodities as long as your calendar shows it is still 2011. As my friend and the head of commodities research at Nirmal Bang Securities, Kunal Shah, says, “the commodities story is over for the year.”

Is it really a coincidence that this steep fall in commodity prices has come just when Ben Bernanke’s second round of monetary expansion, called Quantitative Easing 2 or QE2, is about to come to an end? Bernanke has been churning out $75 billion of newly printed dollars every month since November last year with a target to reach a total of $600 billion by June 2011. That expansion is almost done and it is clear that the Fed is fast running out of options to keep the financial markets on a steroid.

So, when the QE2 tap runs dry on July 1, who is going to come and replace the Fed to keep up the liquidity in the market? No one. In fact, all the bondholders and commodity investors will come to the market at once to sell. But if you are a smart speculator, you won’t wait for others to make a move. You will preempt that bearish hug and sell a month early. May first week, maybe?

The truth is that the financial markets all over the world are going to see dramatically lower liquidity in the months to come.

And the news coming out of global economies is worrying to say the least. Real inflation in the US has been creeping up and undermining consumer spending, even though the headline inflation numbers look very low. This is so because the US Consumer Price Index gives a heavy weight to housing prices which have not recovered at all. Shah of Nirmal Bang has done some arithmetic on this and says the US inflation could be as high as 6 percent if the weight for housing prices is lowered to a single digit percentage.

Europe is in a muddle. China is deliberately bringing down its GDP growth rate to about 7 percent from 10 percent plus to combat inflation. That’s bad news for the world because China had been slowly replacing the US as the lead demand creator for the world’s goods and service.

Commodity prices had run up so much because of the combined effect of a lot of money coming out of the US and a lot of purchase orders coming out of China. Both factors are vanishing now.

Ben Bernanke is not expected to take the market mayhem lying down. He will try something to boost liquidity. He always has the option of a third tranche of monetary expansion, but most people bet against QE3. Governments all over the world are angry at the rise in commodity prices that has led to protests and disaffection among their people. Also, there is a limit to how much can extra money alone do. When many economies are in the doldrums, the markets can’t hold up forever.

In addition to making commodities costlier for poor people in India, China and other countries, the Fed’s policy has had a devaluation effect on the dollar. Now, as commodity prices fell, the dollar rallied clearing establishing the connection between easy liquidity and the recent bull run.

The US had been witnessing a bond bubble fueled by some of this cash and the lure of near-zero interest rates. Now bond prices will fall and the yields will increase. There could be an exodus from the bond market that will make the commodity meltdown look like a walk in the park.

Equities should benefit from the flight of capital from other asset classes, but if the risk perception turns more negative because of failing economies, they could take a hit too.

It is not the time to panic. If you don’t have your money locked up in commodities or US bonds, it is time to sit back and enjoy the fireworks.