Hedge funds cut commodities exposure

Date: Tuesday, March 25, 2008
Author: Javier Blas and Krishna Guha in London, FT.com

Commodities prices have been falling across the board as hedge funds cut their exposure to one of the most popular asset classes so far this year, suggesting that recent record prices have been buoyed by speculative flows.

The spread of deleveraging to commodity hedge funds could be good news for central bankers – usually afraid of any financial contagion.

Crude oil prices late last week retreated by 10 per cent from the record high of $111.80 a barrel reached on Monday, while other commodity prices have also fallen sharply.

David Holmes, of Dresdner bank in London, said that hedge funds were getting out of many of their positions. “Clearly, they were betting that prices would rise in commodities and now they are reducing exposure and most likely locking in profits.”

The Federal Reserve has long been baffled by the strength of oil and other commodities – especially the recent step-up in prices, which has increased inflation risk and greatly complicated the decision as to how aggressively to ease monetary policy.

Fed officials see no fundamental economic justification for the recent strength. Demand in China and India may be strong, they reason, but that was not news to traders. Indeed, the global growth outlook has deteriorated since the start of the year.

The International Monetary Fund shares the Fed’s view, highlighting in a report published on Thursday a “disconnect between commodity prices and the ongoing slowdown”.

The IMF said that the combination of dollar depreciation and falling short-term real interest rates “has pushed up commodity prices through a number of channels, including by enhancing the attractiveness of commodities as an alternative asset”.

“Overall, these financial factors seem to explain a large part of the increase in crude oil prices so far in 2008, as well as the rising prices of other commodities,” it said.

Fed officials recognise that aggressive interest rate cuts have contributed to commodity strength by weakening the dollar – producing both a mechanical effect on dollar-denominated commodity prices, and feeding investment in commodities as a hedge against inflation and further dollar declines.

Indeed, one reason the Fed cut interest rates by 75 basis points this week – and not the 100 basis points the market expected – was in order to avoid fuelling a falling dollar/rising commodity price spiral. That strategy appears to have succeeded for the time being.

But even allowing for this, policymakers did not believe the rise in commodity prices this year was justified on economic grounds – leading them to attribute much of it to financial developments.

If financial forces were the main drivers behind the recent spike, then deleveraging – driven by tighter bank lending to hedge funds and losses on other assets – should deliver lower prices. That would reduce inflation risk and give central bankers greater latitude to ease monetary policy to combat the risks to growth.

However, the IMF warned against any expectation of a large decline in commodities prices, cautioning that markets remained tight and demand in countries such as China, India or Brazil was strong. “Unless there is a substantial global downturn, the extent of easing may be small,” it said.

It added that the apparent disconnect between rising commodities prices and the global economic slowdown reflected the fact that developing countries, which have been responsible for the bulk of recent commodity demand growth, have so far been less affected by the credit crisis.