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What’s Causing The Commodity Price Rout?

02

April, 2013

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Have you been watching commodity prices lately?  Bloomberg describes the recent rout recent rout  ?

Corn, silver and rubber tumbled into bear markets, joining slumps in commodities such as sugar and wheat, on signs that expanding supplies will outpace demand amid increasing concern that global growth will falter.

The price of corn in Chicago plunged the most in 24 years yesterday, leaving futures down 23 percent from last year’s closing high and exceeding the 20 percent benchmark for bear markets. The Standard & Poor’s GSCI Agriculture Index of eight raw materials touched a nine-month low yesterday, falling 21 percent from its 2012 peak.”

No doubt this must be the result of over supply and less global demand?  Right?  Isn’t that how markets are supposed to work?  But why the crash so suddenly?  What happened to the efficient market hypothesis?

Well, a new paper titled “Quantification of the High Level of Endogeneity and of Structural Regime Shifts in Commodity Markets”  sheds some new light on the pricing of commodities. The paper states that “at least 60–70 per cent of commodity price changes are now due to self-generated activities rather than novel information.”  And what are these self-generated activities?  The authors state:

For all analyzed markets, we have found high levels of endogeneity. On average, our conservative estimates show that more than one out of two price changes is due to another preceding price change since the second-half of the 2000s, and not due to an exogenous piece of news. In other words, price dynamics on these commodity markets are partly driven by self-reinforcing mechanisms. In our view, this evolution partly reflects the development of algorithmic trading and of high frequency trading in particular.

The authors talk about the feedback loop that is occurring in the commodities market:

These high levels of endogeneity are likely to make the price formation process less efficient, because higher endogeneity implies a longer convergence process. Moreover, it also points to a growing instability of the system.”

The authors are basically saying that commodity prices are not being set by news events like droughts or a good harvest but are now being set by the activities of algorithmic and high frequency traders who could care less about news events.  Now, how is a financial journalist supposed to weave this into their headlines about the commodity market rout?

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