Commodities Held Back by Chinese Inflation

You may have noticed something strange lately. Though the bulls have been stampeding, commodities just haven't been getting the job done.

All the old relationships seem to be out of whack. For example, less than two weeks ago I wrote to you about "the great decoupling," i.e. the growing disconnect between oil and top stocks for 2011. As I write, stocks are modestly higher, yet oil is cratering.

You can see the disconnect via this chart of the Reuters/Jefferies CRB index:

The CRB index tracks a basket of major commodities. Right now, the price action in CRB is middling at best. The 50-day exponential moving average is close to flat. What's worse, prices are headed in the wrong direction, having failed twice to retake the average or break previous resistance.

The weak price action in commodities comes against a backdrop of renewed equity strength. Financials, banks, homebuilders – all have ripped higher in recent days.

Theoretically at least, renewed optimism for the U.S. economy should be inflationary. If things are getting better for consumers and the banks, then monetary velocity should be picking up. Stagnant pools of lending dollars should be flowing again. All this should be bullish for commodities (and prices in general).

Why isn't it?

One potential reason is Chinese inflation.

Slamming on the Fiscal Brakes

China's economy is showing signs of overheating. This, in turn, has led to concern over what the PBoC (People's Bank of China) may do in response to keep inflation in check.

If China taps on the brakes too hard, as the CEO of Caterpillar so memorably put it, the result could "send everyone through the windshield."

Chinese authorities have stated with confidence that things are still under control. But this isn't really news, because what else would they be expected to say? Evidence on the ground suggests otherwise.

"China's accelerating inflation has started to erode household savings," Bloomberg reports, "threatening to spur purchases of property and top stocks for 2011 and fuel asset-price pressures."

Chinese consumer prices rose the most in 16 months in February. Food prices saw some of the biggest gains. "A potentially troublesome sign for Beijing," The New York Times notes, "given that the Chinese on average spend a third of their income on food."

"Inflation may top the 3 percent policy target by April, which is bound to trigger further monetary tightening," says Dariusz Kowalczyk in Hong Kong.

Inflationary Boom Psychology

The open questions here are 1) whether China will wind up doing "too little, too late" in its inflation fighting efforts, and 2) whether China will have to recreate the Volcker experience to get a handle on things.

Once the ball of inflationary expectations gets rolling, it can be very hard to stop. On every continent save Antarctica, the phenomenon has played itself out over and over again.

In China it might look something like this:

• Mrs. Wen notices that food prices are rising faster than her annual rate of deposit.

• In a bid to avoid the erosion of purchasing power, Mrs. Wen looks to either borrow or invest.

• If she borrows, she does so with the conviction that prices will be higher tomorrow than today.

• If she invests, she is hoping to outpace inflation by capturing a higher rate of return on her assets.

• This borrowing and investing activity feeds the accelerating inflationary boom.

This is the pattern that existed in the late 1970s. Consumers were borrowing like crazy, knowing the thing to do was leverage up and buy now, paying back the debt in cheaper dollars tomorrow. Investors were also going crazy with inflation-linked asset plays, plunging headlong into oil and gas partnerships and the like.

Volcker On Steroids?

The U.S. inflation and stagflation of the 1970s led to huge profits for some. But it was bad news for America's economy on the whole. Fed Chairman Paul Volcker finally stepped in and "broke the back of inflation" by raising interest rates sky high over a multi-year period.

The economy experienced painful recession under Volcker. But it was widely agreed that something had to be done.

In seeking to rein in inflation, Chinese authorities may have an easier time of it than Volcker did. This is because they have more control. Whereas Volcker could not give direct orders to the major banks, Beijing can do just that.

Any move on China's part to "break the back of inflation" could still be painful, though. Slowing down a runaway economy is no easy task. It is less like conducting an operation with precise surgical tools, and more like hitting a mule over the head with a sledgehammer. In order to slow the mule down, you have to swing hard enough to make an impact on his thick skull. But if you swing too hard, of course, you risk knocking the mule out cold.

The evidence suggests Beijing may be forced to move sooner rather than later. This fear of China's next actions – how hard they come down on inflation pressures – could be the main thing holding commodities back. A slam on the fiscal brakes for the world's No. 1 growth story would lessen the attraction for hard assets, at least in the near to intermediate term.