Athoughtful new paper from researchers at the University of Illinois marks a significant step forward in research on how commodity futures prices are formed.
Until recently, the academic and policy debate about futures price formation has been locked in an acrimonious and polarized standoff between market fundamentalists, who insist all price moves reflect supply-and-demand fundamentals, and those writers who blame speculators for every rise in food and fuel prices.
Anti-poverty campaigners focus on the role of speculation because they want governments to impose more controls on the cost of food and fuel. Free-market economists stress the role of fundamentals to deny governments any ammunition to meddle.
Both positions are extreme and unconvincing.
Now Xiaoli Etienne, Scott Irwin and Philip Garcia have published an innovative paper examining the evidence for temporary price bubbles in markets where prices are otherwise driven by fundamental factors.
According to the authors, futures prices for grains, livestock and soft commodities like sugar have all exhibited multiple bubbles over the last four decades, with bubbles more common in the 1970s and again in the 2000s than during the 1980s and 1990s.
Bubbles pre-date the rising popularity of indexing strategies and the “financialization” of commodity markets. There is no evidence bubbles have become more frequent or larger following the entry of more financial investors into commodity futures markets since 2005.
“Bubbles existed long before commodity index traders arrived and the process of commodity market financialization started,” according to a paper on “Bubbles in Food Commodity Markets: Four Decades of Evidence” presented at an IMF seminar in Washington on March 21.
In fact most of the biggest and long-lasting bubbles occurred in 1971-76. Financialization may have ensured bubble-like price movements are now smaller and reverse more quickly.
“Compared to the post-2000 years, speculators and irrational traders (may have) played a greater role influencing prices in the 1970s because markets were less actively traded. The arrival of new traders in recent years, coupled with a dramatic increase in trading volumes, has increased market liquidity, apparently reducing the frequency of bubbles,” the authors write.
The authors speculate bubbles may be driven by herding behaviour, momentum trading or other “noise traders.”
“One possible explanation may be that markets are sometimes driven by herd behaviour unrelated to economic realities… As markets overreact to new information, commodity prices may thus show excess volatility and become explosive.
“It may also be that there are many positive feedback traders in the market who buy more when the price shows an upward trend and sell in the opposite situation. When there are too many feedback traders for the markets to absorb, speculative bubbles can occur in which expectations of higher future prices support high current prices.
“It may be fads, herding behaviour, feedback trading, or other noise traders that have long plagued futures markets were highly influential in recent price behaviour. Recent empirical evidence does suggest that herding behaviour exists in futures markets among hedge funds and floor participants.”
The paper concludes with an appeal for more research to identify the source of bubble-like price behaviour.