Commodity markets need international oversight, more transparency and intervention to deflate bubbles because increasing speculation means prices are no longer driven by supply and demand, the United Nations said.
Increased investment in commodity markets has encouraged “herding behavior” and creates bubbles, the UN’s Conference on Trade and Development said in a report published today. Anticipation of the global economic recovery played a “disproportionate role” in higher commodity prices, it said.
“Prices can move far from levels justified by the fundamentals for extended periods, leading to an increasing risk of price bubbles,” the UN said in the report. “Due to these distortions, commodity prices do not always provide correct signals about the relative scarcity of commodities.”
The UN’s Food Price Index neared a record set in February last month as commodity futures gained. Corn on the Chicago Board of Trade and silver have more than doubled in the past year and gold is up 27 percent. Rice is up 32 percent.
The “financialization” of commodity markets that’s increased since 2004 has led to a lack of “price discovery” that farmers and miners use to make hedging decisions, according to the UN report.
“Market participants make trading decisions based on factors that are totally unrelated to the respective commodity, such as portfolio considerations, or they may be following a trend,” the UN agency said. “The price discovery mechanism is seriously distorted.”
Providing more timely data on fundamentals, information about market participants, especially in Europe, increasing position limits and banning proprietary trading by financial institutions that are involved in making hedging decisions for their clients are ways to solve problems associated with speculative investments in commodities, the UN said.
Introducing a tax system that slows financial market activities and more government involvement in trading is needed to ensure traders are considering supply and demand fundamentals when investing, it said.
Making decisions that ignore fundamentals such as the amount of stockpiles available, weather and demand for agriculture commodities work against assumptions of the so-called efficient market hypothesis, according to the report. That theory states that prices will rise or fall based on supply and demand, according to the UN.
“Contrary to the assumptions of the efficient market hypothesis, the majority of market participants do not base their trading decisions purely on the fundamentals of supply and demand,” the UN agency said. “They also consider aspects which are related to other markets or to portfolio diversification.”
Herd mentality takes over when traders make investment decisions based on what others are doing or when they follow trends that aren’t fundamentally driven, according to the report. Study organizers who interviewed 22 market participants reported “widespread herd behavior,” the agency said.
“Physical traders, in particular, emphasized that the activities of financial players have strong effects on commodity markets and sometimes impair the functioning of commodity futures for hedging,” according to the report.