Why Commodities Prices May Rise, Even In Deflation

As people like Mish point out, we're currently in a highly deflationary environment. As such, commodities would seem to be a poor investment.

But Jim Rogers says that agriculture will go through the roof. A lot of people say gold will soar. And peak oil advocates say that oil will skyrocket.

So who's right?

Well, it isn't a big secret that China is going all over the world buying up commodities.

And an article in the Financial Times yesterday entitled "Hedge funds turn to gold" notes:

Hedge fund investors who made money last year by betting against investment banks are now buying gold as a way of betting against central banks....

[Hedge fund managers] such as Mr Einhorn are turning to gold because they are worried about the response of the US Federal Reserve and other central banks to the global economic crisis. A bet on gold is essentially a bet against all paper currencies.

“The size of the Fed’s balance sheet is exploding and the currency is being debased. Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed,” Mr Einhorn wrote in a recent letter to his investors. “Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself.”

Mr Einhorn’s comments – and the revelation he is buying gold itself – are in line with the views held by other large institutional investors in Europe, according to bankers in London. The head of commodity sales at one major bullion bank told the Financial Times that he had never been so busy dealing in gold for large investors in his life.

Goldman Sachs, Morgan Stanley and UBS all forecast the gold price will surge above $1,000 this year. Peter Munk, chairman of Barrick Gold, the world’s largest miner of bullion, told investors last week that all countries have embarked on policies that will favour gold.“The only option to governments is to print and print more money,” he said. “That will end in tears.”

Moreover, the government is in the process of giving hundreds of billions - if not trillions - of dollars and guarantees to hedge funds. Whether the hedgies directly use that money to invest in commodities, or use other monies they possess, the shot in the arm of cash and guarantees from Uncle Sam is going to restart a speculative frenzy by the hedgies.

Finally, financial blogger Mike Whitney also makes a good point about another factor driving up commodities prices:

There is another part of Geithner's plan that is even more troubling, that is, after the banks sell their dodgy assets to the hedge funds, what will they do with the money? Consumers are retrenching, so the pool of creditworthy customers will remain small. And businesses are trying to work off existing inventory, so they won't be borrowing to increase investment or retool anytime soon. If the opportunities for lending dry up, the banks will be forced to seek unconventional means for generating profits. My guess is the banks will put a large portion of their money into hedge funds for commodities speculation, which will push the price of oil, natural gas and other raw materials into the stratosphere just like they did last year when oil shot up to $147 bbl. The banks really have no choice; 65 percent of their business was securitized investments. That door has been slammed shut for good.

The bottom line is that, even in this highly-deflationary environment, commodities may do fairly well this year.

And eventually, most analysts think deflation will give way to inflation. Whether that happens in the short-term or long-term is open to debate.

Note: I am not an investment advisor and this should not be taken as investment advice.