The importance of money flows from it being a link between the present and the future.
John Maynard Keynes (1883-1946)
In order to understand the commodity markets, we need to step back in time a little and consider them from several different perspectives, for two reasons.
First, they are the only one of the four capital markets, where real physical goods are bought and sold.
Second and, perhaps more importantly, this market has changed beyond all recognition in the last ten years, and just like the bond market, is one few forex traders ever consider.
Sadly, this again is a huge mistake and, in writing this book, is one I hope to correct, as the commodities markets play a key role as the fulcrum of the financial markets.
The commodities market is the fulcrum of the financial markets because it is where real currencies are converted into real products, creating a myriad of pivotal relationships, as the world of money meets the real world of economic supply and demand in commodities.
Commodities therefore provide the ultimate bridge between global economies and the US dollar, bonds, equities, and of course currencies. Without this bridge and real global market, we would have little idea of what is actually happening in the world. Few forex traders appreciate the significance of this market, not only in terms of its position at the centre of the money flow, but also in terms of how this market is viewed, by both central banks and
governments alike in their key decisions.
It is equally as important as bonds, and perhaps even more so, and this is one of the pivotal relationships I will cover in detail later in the book.
Commodities are a key component to your trading success. As traders we have to understand them, the signals they are sending regarding the economy, associated markets, and of course money flow and risk appetite.
Put simply, commodities are the shop window of the world – a trading post, a giant store where real goods are exchanged for money and money is exchanged for real goods. The ultimate warehouse on a grand scale.
The commodities market was founded on the need for farmers in the US mid West to have a fair and equitable market in which to sell their crops and livestock. From this, the futures market was born, which is why many of the largest futures exchanges, such as the CME ( Chicago Mercantile Exchange ) and the CBOT ( Chicago Board of Trade ) are still based in
Chicago, with these two exchanges merging in 2007.
Whilst I will be explaining how to trade currencies using futures in another book, let me just outline the basics of a futures contract.
A futures contract is simply a contract between two parties which specifies that on a certain date in the future, the producer or holder of the contract agrees to deliver a specified quantity of the goods, at a specified time, for an agreed price.
In this way, growers and producers in the mid West were able to agree a price for crops and livestock for delivery in the future. This in turn removed the uncertainty of future price
fluctuations caused by natural events, such as poor growing conditions, bad weather, natural disasters and world conflicts, allowing both parties to plan their cash flow accordingly.
Over time, the commodities market expanded to include not just the agricultural sectors, such as corn, wheat, dairy, livestock, coffee and cocoa, but into a huge variety of sectors, including metals, (precious, industrial and base), along with energy sectors, such as oil and gas, index futures such the S&P500, and other financial instruments.
Up until the late 1990's, the commodity market was considered to be a specialist one, little understood by the average trader.
Contracts were traded through the central exchange using open outcry in the pit, with the markets only trading when the exchange was physically open.
As we moved into the21st century, everything changed with the advent of electronic trading.
No longer was it necessary to call a specialist broker and instruct then to execute a buy or sell order for wheat or cotton. Now it was possible to trade online virtually 24 hours a day.
This simple innovation has changed the commodities market from one of a simple supermarket to one where commodities are now considered as an asset class, just like any other. This is also the case with currencies, which just like commodities, are bought and sold as an asset, and not purely for short term speculative gains.
One of the common misconceptions is that commodity exchanges determine or establish the prices at which commodity futures are bought and sold. This is false. Prices are determined solely by supply and demand.
If there are more buyers than sellers, then the price will rise. If there are more sellers than buyers then the price will fall. This is generally referred to as 'price discovery' but in simple terms all this means is that this is a free market, where prices find their natural level. This is why the commodities market is so important and why it gives us so many signals as a result.
But, why does it matter?
If I were writing this book twenty years ago, in considering this market we would be looking at two principle relationships.
The first would be with the US dollar, and indeed this still remains an integral part of our analysis, since virtually all commodities are priced in dollars.
The second would be the economic relationship with inflation. This is a key reason why we monitor the commodities markets so closely and which also explains why there is such a close relationship with bonds.
However, we now have to add a third strand to the analysis, which is money flow, since
commodities are considered to be an asset class in their own right. This means that commodity futures and, in some cases, the physical asset is being bought and sold as an investment, either speculatively or for a longer term buy and hold. This is a similar approach to that in equity markets and, as a result, commodities can now tell us a great deal about risk and market sentiment.
Therefore to summarise. Any analysis of the commodity markets will tell us three key things.
First, what is happening in the global economic picture, and therefore what is likely to happen to interest rates, as inflationary pressures increase.
Second, the future direction for the US dollar.
Third, risk appetite and sentiment, and therefore money flow, as most commodities are considered to be high risk.
Later in this chapter I will be considering some of the individual commodities in detail, such as gold, oil, copper and, of course, the US dollar, but the key point to start with is this – commodities and fundamentals go hand in hand.
When interest rates rise, for example, commodities are likely to perform well. And the reason is because, rising rates are likely to indicate increasing global demand, which in turn drives inflation into an economy, which is good for growth.
Commodities give us a classic view of global demand for raw goods and with their key relationship with the US dollar reveal both money flow and market sentiment. Indeed it could be argued that to be successful as a forex trader, you simply need to have a clear view on the US dollar, since every other market, from bonds, commodities, equities and currencies is US dollar centric. The dollar remains the currency of first reserve and until an alternative is found, will remain so for the foreseeable future!
Whilst forex markets underpin the other three, it is commodities which provide that real world linkage, the bridge between money and goods. They are the fuel of the economy. Japan cannot make cars without steel. Nothing moves without oil. The mobile phone market needs rare earth metals, and you cannot feed the world without wheat, corn or soybeans.
The complicating factor now, of course, is that we have to view some commodities as an asset class in their own right and therefore be careful in our conclusions and analysis. Later in this
chapter we are going to consider some of the key relationships such as commodities and bonds, and commodities and the US dollar which will help in confirming any conclusions we may make. However, before doing so, I would like to spend a few moments considering the broad sectors, and some of the key commodities in each.