Abheek Barua: Out of the woods yet?

Current rally in commodities & currencies is likely to be limited, as supply corrections can only partially battle subdued global demand

Commodity prices in global markets have been rising almost continuously since February. The CRB index, a widely used index of commodities, shows a 10 per cent escalation since mid-February. Copper, to take a specific example, is also up some 10 per cent in this period. Currencies and stock markets of major commodity producers like Russia, Brazil and Indonesia have recovered sharply. The bets that crude oil would touch 20 or even 10 dollars a barrel seem to be off the table at least for now.

This particular rally in commodity prices is what one might call a "risk-on anti-dollar" rally. The dollar has fallen not just against commodity-linked assets but against other asset prices as well. Emerging market currencies like the rupee that are not directly linked have also gained, as investors have started to take more risks and climb out of the safe haven of the dollar and dollar assets like treasuries.

The obvious question then is: will this rally last? Some argue that since nothing much has happened to demand (there aren't any signs that growth in the major commodity guzzlers like China is picking up), this is just a case of dumb money chasing a bubble. And yes, there's cheap money sloshing around courtesy the European Central Bank's decision to print more euros and cut their already negative interest rates further on bank deposits with the central bank. The Bank of Japan is likely to start printing more yen to unleash a round of quantitative easing and the US Fed seems unsure of whether it is in a position to raise rates. Whether this embarrassment of liquidity is fueling dumb trades is the critical issue.

There is an alternative view. This points to the fact that supply of major commodities is reducing sharply. Take copper again. Producers who had been holding on to output for much of 2015 in the hope of better prices have started paring production from late 2016. Miners including London-listed Glencore, US-based Freeport and Poland's KGHM have already reduced production. With 50 per cent of the miners around the world running operating losses, more supply cuts seem likely. This is happening with other commodities as well. This moderation is likely to set a floor to commodity prices this year even if the rally loses momentum. So 2016 could set a base and could see the beginning of a secular rise in commodity prices.

Let me go with this view and explore the implications. If commodity prices do rise, it might arrest the deflationary trend that has bogged down economies across the world. Central bankers who have trying to battle this deflation with every trick in their books (from overworking their money-printing machines for quantitative easing to offering negative interests for excess cash that banks want to hold with them) can breathe a sigh of relief. If the rise and stability in prices continues to take the sting out of the dollar's appreciation, it might mean more flows into other markets including India.

Commodity producers whose balance sheets and P&Ls have been battered over the last couple of years have also contributed the bulk of non-performing loans not just in India (where steel producers for instance contribute a hefty fraction of bad debt) but in other countries like China. They might see the first signs of revival and ease the pressure on the banking system.

That said, this rise in prices is could turn out to be a mixed blessing. The anti-dollar trade is the flipside of the commodity run. That's suddenly led to a surge in portfolio flows and appreciation in non-dollar currencies. The rupee is suddenly looking a trifle overvalued and the RBI has been buying dollars aggressively to thwart this.

Then there is the business of inflation. Higher commodity prices could mean that we might lose the little help that we have had for the last couple of years on the inflation front from softer prices. This would be particularly problematic if oil prices start to rise too. Besides, the flood of capital inflows might mask a creeping rise in imports that would slowly widen the current account deficit. And so on and so forth.

The biggest risk in my opinion stems from the baffling circularity with which markets often think about things. If global deflation tends to ease, markets will slowly start worrying about the US Federal Reserve hiking rates. If indeed one goes with the assumption that the Fed is the pivot around which markets move, there could be a situation when the markets start factoring in an imminent US rate hike. This could lead to a flight of capital from risky assets like emerging market debt and stocks. India has a current account deficit to fill and a "sudden stop" in capital flows would be far more difficult to handle than a surge of inflows.

My prognosis is that the current rally in commodities and currencies is likely to be limited. Global demand is still subdued and while supply corrections can help improve the balance, it cannot take prices up much further. Besides, all the risks are still on the table - another mini-crisis in Europe, the prospect of Britain leaving the EU, further bad news from China (particularly from its financial sector), and the prospect of the Fed hiking rates. Yes, the stock market here could climb a little higher and the rupee could rise a little more. However, the second half of the year could tell a different story.

The writer is chief economist, HDFC Bank