The Fed Is Inflating Commodity Prices

As traders deal with the bear market in equities, the commodity markets have gone parabolic. This action in commodities has been at odds with the assumption of many traders recently that the domestic financial crisis would drag the global economy down and slow commodity consumption.

We believe the strength in commodities may be a symptom of the excess liquidity being created by the Fed to deal with the banking crisis. If this is indeed the case, we would look for an even more exaggerated move in the commodities market as the Fed is forced to lower rates even further to deal with a faltering domestic economy.

The Fed's policy is "growth first," which means it will do what it has to get the economy back on track and worry about inflation later. The massive liquidity the Fed will have to inject in the financial system to help hold it together will definitely have consequences. We wonder if we aren't already seeing some of these effects take hold in the form of higher commodity prices.

The Commodity Research Bureau index started to rally at the same time the Fed started cutting rates. This may be coincidence, but it looks interesting to us. The spread between the two-year bond and the Fed funds rate has widened even more recently. This spread suggests that the Fed continues to lag and needs to lower rates even further to re-liquefy the banking system.

The surge in commodity markets will drive earnings higher for companies in commodity-producing emerging markets. Strength in earnings should drive liquidity into those emerging markets once trader sentiment turns slightly more bullish. The MSCI emerging-markets index is holding the uptrend channel and remains in a long-term bull market.

We're seeing some interesting strength in the South American markets in particular. Strength in gold and weakness in the dollar continue to support the idea of endemic inflation. The consumer price index is still lagging the CRB index on a relative basis; this suggests that commodity inflation is accelerating, but inflation hasn't made its way into finished products.

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The breakout strength in commodities is compelling and should suggest to traders that the excess liquidity being created by the Fed is starting to go somewhere, and that there is more to come. The commodity trade could take some hard hits if there is real evidence of an emerging-market slowdown, but we haven't seen any signs of this just yet.

Traders can take a look at the Powershares Commodity Tracking ETF (DBC - commentary - Cramer's Take) if they want to get long the commodities market. DBC has recently broken out to the upside of a large bullish rectangle consolidation pattern within the uptrend.

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Traders can get long here, but a pullback toward $32 would be an optimal entry point. A break below $30.25 would suggest a bearish change in the commodities market and take the group off of the offensive. We would use the $30.25 level as a stop loss.

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At the time of publication, John Hughes and Scott Maragioglio had no positions in securitied mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.