Commodities And Yields Are Declining - This Is Why

Summary

A stone thrown in a pond makes smaller and smaller waves.

Any system subjected to a shock responds irregularly until it reaches equilibrium.

Any economy subjected to a shock responds with oscillating random waves until it reaches its long-term growth rate.

Men Going Around a Warehouse

Pexels

The main force driving the economy is the business decision to control inventory levels. The monthly inventory to sales ratio released by the Census Bureau provides important data. 

A rise in the inventory to sales ratio means inventories are rising faster than demand. The business response is to reduce them. Production needs to be cut. Purchasing of raw materials must be reduced. Hours worked and labor are lowered. Borrowing is also curtailed since less capital is needed to finance operations.

The market response to these decisions is declining commodity prices and interest rates.

The opposite takes place when the inventory to sales ratio declines, reflecting the need to replenish inventories since sales are outstripping inventory growth. Production needs to be raised. Purchasing of raw materials must be increased. Hours worked and employment are expanded. Borrowing is also increased since more capital is needed to finance operations and capacity expansion.

The market response is higher rising commodity prices and interest rates.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above chart shows the change in the inventory to sales ratio of three industrial segments: manufacturers, wholesalers, and total business.

The inventory to sales ratio (April data) has been sinking, reflecting demand outstripping supply by a wide margin. The last time it happened with similar violence was during the great recession of 2008-2009. Business will continue to respond by aggressively increasing production. This is the major business activity supporting the economy until inventories are growing at the same pace as sales.

The weakness in commodities and yields will provide an important clue whether inventories are finally outstripping demand and there is an unwanted inventory accumulation. It will take a few more months to find out. Commodity prices, however, being an important leading indicator, will provide important clues on the direction of the business cycle.  

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