Often the best way to predict future economic data is to see what happened in the past. Last year saw rapid increases in the price of many commodities (despite low global inflation)

The price of many commodities increased, but, in particular commodities such as Gold, oil,  energy sources and soft commodities such as coffee and wheat.

Source: Bloomberg Commodity prices 

What will determine the price of Commodities in the next year?

Like any good, we can explain price changes and predict future price changes on the basis of supply and demand.

On the demand side we have seen strong economic growth in Asian countries such as China, India and to a lesser extent Europe. Fears of a US recession may lead to slower global growth, but growth from China and India may outweigh the slowdown in US growth. The US no longer dominates the world economy; strong demand will probably be maintained from other countries.

When the Dollar is Weak Buy Gold

Another aspect of commodity prices is the interrelationship between the dollar and commodities. When the major global currency – the dollar is weak – people instinctively look for an alternative and this is usually commodities such as Gold.

With increased economic instability gold is seen as a safe investment. in 2008 and 2009 we are likely to see further problems from the global credit crunch and the US housing market difficulties. Therefore, whilst the US economy remains weak, the dollar is likely to continue falling and Gold will remain an attractive alternative.

Note: this weak the FED cut interest rates by 0.75% a response to economic concerns over the stability of the US economy

Supply Constraints and Future Markets

Another aspect is that the supply of many commodities has been falling due to various factors.

• Global warming is being blamed for falling agricultural production
• Geo-political factors are behind much of the shortage in the supply of oil

Commodity Prediction for 2008 – I feel the factors for rising commodity prices remain in place.

Related 

• Economics Forecasts.org 

Interest Rate Movements.

Interest rates have the biggest single effect in determining exchange rates. Higher interest rates make it more desirable to save money in that particular country. This causes an inflow of hot money which leads to an appreciation in the exchange rate. International hot money flows account for a high % of capital flows.

Economic Prospects

Linked to interest rates is the general economic prospects of an economy. If an economy is slowing down, due to say falling house prices, it is likely that interest rates will fall. This is because when the economy slows down, inflation falls allowing Central Banks to cut interest rates. E.g. slower growth in the US has caused expectations of interest rates to fall, this in turn has led to the devaluation of the dollar.

Expectations / Confidence

This is an important factor which is harder for Economists to quantify. When Keynes was formulating his general theory, he used the rather unscientific term ‘animal spirits’. Here he was referring to business confidence. But it would not be entirely inappropriate to explain sentiments in foreign exchange markets. If people expect a currency to devalue, then it can become a self fulfilling prophecy. Because people expect the currency to fall, they sell and this causes the currency to fall. Because of the importance of expectations and market sentiment, currencies can often become divorced from economic fundamentals. This means that currencies can overshoot or undershoot their expected value.

• For example, 2007 saw a weak dollar due to falling interest rates, however, the bearish sentiment caused the dollar to fall by more than perhaps was warranted. the Pound reached $2.12 before falling back to $1.95 a few weeks later. Like other markets, currencies can get caught up in their own hype – making forecasting a difficult business.

Long Term Competitiveness

It is argued that in the long term exchange rates will change to equalise differences in purchasing power. An example of this is using the Economist’s Big Mac index. This shows the local dollar price of buying a big Mac. Countries where a Big Mac is very expensive, in theory, have an overvalued exchange rate. In principle, their exchange rates should fall in the long term to equalise the purchasing power of the currencies. However, currencies can be ‘overvalued’ or ‘undervalued’ for a long time due to other factors like general economic confidence.

Example, the dollar is weak, making it cheaper for Europeans and Canadians to buy American goods. In theory, this should lead to a long term appreciation in the dollar. However, in practise, their is no guarantee that this will occur.

• Predictions for Australian Dollar 2008
• Predictions for US Dollar 2008
• Prediction for Pound Sterling 2008

Prospects of growth in 2008, look reasonably good; buoyed by consumer spending growth is forecast to be 2%. With inflation under control the Japanese Monetary authorities are unlikely to change interest rates.  (interest rates are currently close to 0%)

Forecast Yen against the Dollar

The US economy appears to have more structural weaknesses than Japan. With US house prices still falling and further fallouts from the sub prime crises the American economy faces the prospect of recession. It is likely that the Fed will lower interest rates in the US, despite this further undermining the dollar. Therefore, the long term trend of Yen appreciation against the dollar is likely to continue

Graph of Yen against US $

Forecast of Yen against Euro

The Euro and the Yen have been quite volatile in 2007. This is because the Yen is often used to finance carry trades. When the stock market is rising investors sell their Yen assets and invest in shares. When they want to borrow money they use the Japanese Yen, because it offers the cheapest interest rates .

In the past 6 years, the yen has fallen 37 percent against the euro. However, this prolonged decline may well becoming to an end. There is only so far that the Euro can keep rising without causing pain to the EU economy. In the near future, the markets may seek to correct the 6 year trend and revalue the Yen at 120 per Euro.