NEW YORK (CNN/Money) - It's easy to come up with solid, fundamental reasons for the sharp rises we've seen in many commodity prices. Unfortunately, it may be more than the fundamentals that are pushing everything from cotton to copper higher.
Ask around Wall Street why materials' prices have rallied so hard, and you'll invariably hear the word "China" far up in the conversation. The Mainland is manufacturing like mad (something that almost everybody expects to continue) and that's pushed its need for raw materials markedly higher. Meantime, commodity producers, burnt badly in the past, have not added to their capacity in response to the increased demand. Put the two together, and you get higher prices.
You're also likely to hear about the dollar fairly high up in that conversation. The greenback is weak, and almost everybody expects that it's going to get weaker. That's supportive of commodity prices, since it's not just people with dollars in their billfolds that buy commodities, but people with euros and yen and what have you.
Now let's pair China and the dollar. Imagine what happens if at some point in the next year Beijing allows its currency to slightly rise against the dollar -- something which, needless to say, just about everybody expects. That's going to increase the Mainland's purchasing power, allowing it to buy even more raw materials.
But when everybody expects something to happen, markets get dangerous. This is no exception. Speculation in commodity markets has become rampant. Merrill Lynch strategist Rich Bernstein points out that the weekly commitment of traders report from the Commodity and Futures Trading Commission shows that "non-commercial" traders (hedge funds, mostly) have the largest net long positions in commodities that they've had in at least a decade. (In the dollar, it's the opposite case -- everybody is betting on a decline.) Meantime, 70 percent of global fund managers Merrill polled in a recent survey expect commodity prices to rise over the next year.
The enthusiasm for commodities, wrote Bernstein in a report Tuesday, means the runup in prices may not be due just to improving global demand, but to speculative excess. This opens the possibility for a sharp drop in commodity prices -- one factor that makes Bernstein somewhat less-than-sanguine about the prospects for basic materials stocks.
What could serve as the catalyst for a drop in commodity prices? As with so many things these days, the answer is China. Amid signs that Beijing is trying to rein in too-hot growth, some observers worry that China could face a hard landing. That could remove a huge source of demand for commodities from the global marketplace and, points out Dresdner Kleinwort Wasserstein global investment strategist James Montier in a recent piece, leave many hedge funds doing a Wile. E. Coyote imitation.
"If the price of commodities drops due to a change in the fundamentals relating to China, then the speculative element of the market is running in the air without any support," Montier wrote.
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