Beware a Commodities 'Melt Up'

A broad advance in raw-material prices could trigger the double-dip recession we've all feared.
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The crude-oil breakout may induce sympathetic rallies in other commodities, triggering a broad "melt up," like the one we saw in 2008. Unfortunately, the world economy is far more fragile now than it was two years ago and could suffer badly if raw-material prices go through the roof.

In fact, it might trigger the long-dreaded

double-dip recession

. Manufacturers may face a dilemma: If they try to pass on the higher costs of production, consumers who are just starting to spend more freely could retreat; if they decide to absorb the added costs, their margins will shrink. Either way, profits would suffer, and the affected companies will be forced to shelve expansion and hiring plans.

Expect Wall Street to downplay the negative effects of a broad commodity rally, as it did in 2008, because it's out of touch with Main Street realities. Wall Street believes consumer buying habits will move in lockstep with stock prices, and nothing else. I believe that's a misguided view because $4 or $5 per gallon at the pump will take a big bite out of our already reduced purchasing power.

However, I'll temper my pessimism until crude oil reacts to resistance near $90 (red circle). The futures contract has been pushing higher in a rising channel since June, 2009, with that level marking the top of the channel, as well as the 50% retracement of the 2008 decline. A reversal near this barrier may induce a downturn that drops price back to channel support, currently near $73.

That rollover would take a lot of heat out of the energy markets and dampen hedge-fund enthusiasm for momentum trades in other raw-material contracts, such as copper, silver, and even gold. Alternatively, a channel breakout above that price level would open up a world of hurt because the subsequent rally might not stop at "round number" $100.

I believe crude oil is the most manipulated market in the world. This observation comes from an outsider (that's me), forced for years to watch ridiculous price swings that have nothing at all to do with supply or demand. Indeed, the CFTC's failure to control this unstable market since the 2008 bubble may come back to haunt it -- and us -- in coming years.

My commodity melt-up scenario isn't based solely on price action in the energy markets. The copper futures have also broken out in the past two weeks and are now trading at 18-month highs. I didn't see this coming. I had expected the contract to trade in a narrow range through most of 2010. Instead, copper is moving to test its pre-crash high around $4.25.

The best thing I can say about copper's current positioning is that it

should

take months or years to overcome major resistance at the 2008 high. That barrier ought to slow the rally momentum and keep a lid on the cost of copper-dependent products. At least, we can hope so.

Rising copper prices point to growing confidence in industrial growth through this year and into 2011. There's nothing wrong with that turn of events, or with funds buying the metal in response to positive economic data. But I am worried these predatory and paranoid funds will start to pile on for short-term performance, triggering a 2008-like parabola.

When it comes right down to it, gold futures are the place to watch for a lockstep commodity rally, given the precious metal's longstanding reputation as an inflation measure. The contract appears to be underperforming crude oil and copper, but that's just an illusion, because this year's consolidation follows last year's huge breakout. As the market wisdom goes: the bigger the move, the broader the base.

The weekly chart shows a trading range, with support near $1,085, and resistance at $1,145 and $1,160. The long-term, relative-strength indicators turned higher some two weeks ago, pointing to buying interest that could eventually yield the next leg of a historic uptrend. However, there's really no easy or logical place to jump aboard this incomplete pattern.

For now, should just sit back and watch. Since a good measure of last year's gold breakout reflected fears of hyperinflation, driven by massive government-induced liquidity, this contract should emanate all sorts of early warning signals, if and when raw materials start to translate into higher end costs.

One relatively easy way to get all sorts of commodities to behave themselves again: Raise interest rates. Under the hood, the recent commodity breakout reflects a high level of hedge-fund cynicism for the Federal Reserve and its ability to manage liquidity in the post-crash environment.

The Fed governors' reluctance this week to raise the discount rate reinforces that negative view. The vagaries of Washington politics, as well as the coming midterm elections, are clearly influencing current policy. The FOMC's timidity ahead of elections could be a huge mistake for the world economy.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a private trader and publisher of

Hard Right Edge

, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of

The Daily Swing Trade

, a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in

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,

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. He has written two books:

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and

The Master Swing Trader Toolkit: The Market Survival Guide

, due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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