Metals Commentary: Metal prices’ fall and the bin Laden effect

Friedrich Nietzsche opined that, in its essence, life is uncanny.

The events of the first week of May have left many investors feeling the wisdom of those words.

First came the news that U.S. Navy SEALs had killed Osama bin Laden in Abbottabad, Pakistan, on May 1. The joy and satisfaction felt by most in the Western World quickly led to speculation among investors on how such a momentous event would be interpreted by the markets.

Initially they reacted much as expected, as a positive turn in morning trading on Monday, May 2, seemed to perfectly reflect the joy of U.S. citizens out on the streets the night before with their chants of “U.S.A!”

But such positive momentum was quickly lost and it was commodity investors who were to feel the brunt of the pain. As the week unfolded, seemingly every day brought further drops in the prices of gold, base metals and oil, and the shares of the companies that produce them.

What was going on? Was this a market correction unrelated to the events in Abbottabad? Or could it be that bin Laden’s death was being read by the market as the beginning of a paradigm shift?

Would future historians point to the SEALs’ work as a trigger event that began the end of a market cycle marked by war, inflationary fears and a bull run in commodities?

There is no question that economic growth in the Brazil-Russia-India-China (BRIC) countries has rightly been attributed as a dominant theme in investing over the last decade. But markets are complex, and it would be a mistake to reduce market trends to a single explanatory cause.

By way of experiment, let’s take the BRIC theme out of the equation and look at the past 10 years with fresh eyes. What’s left is a commodity boom beginning shortly after the terrorist attacks of Sept. 11, 2001, that led the U.S. and its allies into wars in Afghanistan and Iraq. The boom has continued, with one glaring interruption in 2008, as war dragged on in both countries – all the while, the U.S. dollar continued to fall.

Are such events related? And if they are, then is it possible that the killing of bin Laden is being read by markets as a signal that this period of American war-making overseas is coming to an end? If so, could one of the key motivators for the commodity boom be winding down?

While the negative correlation between the dollar and commodity prices is well established, the connection to wars needs some elaboration.

The way in which commodity prices can be tied to wars is via inflation. That is, economists widely agree that war and inflation are intimately intertwined.

The basic argument runs thus: a given government engages in deficit spending to fund its wars and such deficit spending creates the conditions for inflation.

Unlike deficit spending on things such as infrastructure – investments that can increase productivity and create new goods and services that soak up the extra cash over time – war-directed spending is marked by the buildup of items that have little trickle-down effect on the economy as a whole.

The explosion of an expensive U.S. bomb overseas doesn’t ripple back to most Main Streets back home, which makes war-time military spending even more inflationary… and makes the loose monetary policy required to fund it even more difficult to reverse.

Under this thesis, the fact that commodity prices broke out of a 10-year-long channel shortly after the start of the Iraq War is no mere coincidence.

Compounding wartime inflation were the much-discussed rounds of quantitative easing that the U.S. Federal Reserve has engaged in to stimulate a moribund U.S. economy.

But even this factor is beginning to lose some of its former steam as commodity bears can take solace in Fed chairman Ben Bernanke’s recent assurance that the Fed’s second round of quantitative easing, or QE2, will indeed end in June 2011. That statement, when coupled with the European Central Bank’s recent tightening, point to higher interest rates in the future and thus to a dampening effect on inflationary fears.

But theory can only take one so far. Now it’s time to see what the charts are saying, starting with gold.

The yellow metal’s sell off after breaking through the US$1,500-per-oz. barrier – it opened at US$1,577.00 per oz. on May 2 – has been swift, as it fell to as low as US$1,462.50 per oz. just three days later.

Perhaps of most concern about the sell off was the increased volume that accompanied it. Using the SPDR Gold Trust shares (gld-n) as a proxy for capital flows in and out of the metal, volume reached a 12-month high of 50 million on May 5 – the very day that gold hit the US$1,462.50 low.

The SPDR S&P Oil & Gas Exploration & Production (xop-n) exchange-trade fund (ETF) showed a similar trend, as its volume hit a 12-month high on the same day, with prices coming off 12% from just days earlier.

And then there was silver. Whatever pain gold bugs and peak oil investors were enduring paled in comparison to that felt by those holding silver.

The macro factors working against commodities as a whole were compounded for silver by an announcement from the Chicago Mercantile Exchange regarding new margin limitations. The CME announced on May 3 that it was increasing the margin limit by 11.6%. The move came due to the record levels of inflows into the metal, but the announcement helped spur a record level of single-day outflows. The increase in margin was the third in a week, and was said to have initially scared off anyone with long positions and insufficient capital.

Technical-chart watchers always take significant movements in price accompanied by such increased volume as a strong signal as to where a new trend is developing. In the case of commodities, the signal is pointing decidedly downwards.

Perhaps most distressing and confounding for commodities bulls, is the fact that the turn for the worse came after both the broader market, and commodities specifically, had proven so adept at shrugging off prior bouts of bad news.

The continuing impasse over the U.S. budget failed to register any significant damage to upward trends, as did Standard & Poor’s pronouncement that the U.S. has a one in three chance of loosing its AAA credit status.

Indeed the credit-rating scare was not only shrugged off by the market, but also gave new legs to gold as the metal broke through the US$1,500 mark just two days later.

It was as though the market was ignoring what should have been bad news for equities, but pricing in its positive effects for gold.

And this after only a few weeks’ earlier, when markets took what should have been bad news for gold – a rate hike from the European Central Bank – and sent the metal’s price higher.

It would seem the underling belief in a weak dollar, looming inflation and ever-increasing Chinese demand, had such a hold on investors that no evidence to the contrary was to be admitted.

But has bin Laden’s killing changed all that?

The story many investors believed would unfold after his death was that the killing would bring markets a jolt of positive psychology, enhance America’s position as the dominant global power and reduce the risk of terrorism, thus sending even more capital into equities.

And while the fall in oil and gold can been seen as supporting such a train of thought – oil because American dominance over Al Qaeda may signal a quicker termination of Muammar Gaddafi’s rule in Libya, and gold because of falling geopolitical risk – the subsequent fall in equities has gone directly against it.

Uncanny indeed.