The Causes of Metal Price Volatility
Why are metal prices volatile?
Following my earlier article, which looked at the most volatile metal prices, I wanted to delve further into the research on metal price volatility. Specifically, I wanted to find out what causes metal price volatility and why some periods are characterized by greater volatility than others.
Beginning around 2000, sharply rising metal prices and a growing influence of financial markets on metal prices led to widespread discussion and analysis of the causes of commodity price volatility.
Below I have summarized some of the most recent literature examining metal price volatility.
It has long been understood that commodity prices are inherently more volatile than many other consumer goods simply due to something economists refer to as price inelasticity.
In other words, if demand for copper suddenly surges, global output cannot respond immediately. Mines must be permitted and concentrators built. Likewise, consumers cannot always substitute one metal for another when prices rise or fall.
The effect of volatility is difficult to measure but is generally seen as negative because it brings with it uncertainty about future price levels. When producers and consumers do not have a good idea of what future prices may be, they are less likely to invest in new production or applications for a metal.
According to a paper published by the Federal Reserve in 2012, the decade between 2002 and 2012 saw a marked increase in the volatility of commodity prices as well as the correlation of price changes across commodities.
Volatility is generally measured as larger than normal deviations from the long-term average price for a given metal.
The authors outline how low interest rates tend to reduce commodity price volatility because the lower carrying costs allow consumers to hold greater inventory, thereby, smoothing over temporary price shocks (e.g. mine strikes or power failures).
Low interest rates, however, have no influence on persistent shocks (e.g. increasing demand from emerging markets).
Empirically examining this dichotomy, the authors conclude that increased volatility over the decade was a result of an increase in persistent shocks to commodity markets (read: China's growing demand).
The Federal Reserve paper also emphasizes the impact of monetary policy on commodity pricing over the influence of financial instruments.
Around the same time, the Reserve Bank of Australia also published a paper that downplayed the influence of financial markets on commodity price volatility.
In this paper, the authors contend that (1) because price increases were equally as large for many commodities without well-developed financial markets as they were for those with futures and derivative markets and (2) they found significant heterogeneity in price movements between commodities regardless of the existence of financial markets, fundamentals remain the dominant factor in determining commodity prices, not the large and growing influence of financial instruments.
They conclude by stating that the post-2000 "increase in prices and volatility is not unprecedented, having occurred during other large global supply and demand shocks throughout the past century." And that "(t)here is a lack of convincing evidence (at least to date) that financial markets have had a materially adverse effect on commodity markets over time periods of relevance to the economy."
Personally, I feel that there needs to be more analysis of financial markets on metal prices. For the most part, the research that has been done has only examined metal markets that are large, established and broadly transparent, such as copper, aluminum, and zinc.
Continuing with some literature, the French think-tank CEPII more recently published a working paper examining whether commodity price volatility reflects macroeconomic uncertainty.
The researchers found that precious metals like gold and silver, true to form, are turned to as a safe haven in times of uncertainty. Other commodity markets also show sensitivity towards macroeconomic uncertainty.
However, these periods of uncertainty, such as during the post-2007 global recession, do not necessarily result in greater price volatility.
Finally, a National Bureau of Economic Research working paper prepared by David Jacks in 2013 examined price cycle trends in 30 commodity markets over 160 years.
Jacks' findings - that there has been an increase in the length and size of commodity boom and bust cycles since the fall of the Bretton Woods system - led him to believe that periods of freely floating exchange rates contribute to the frequency and scale of price volatility.
So, if the research is to be believed, prices for metals and other commodities have experienced greater than average volatility since 2000. This has not been due to increasing, unpredicted supply and demand shocks, but changing fundamentals in the global marketplace.
While the impact of new financial instruments (futures, derivatives, investment funds etc.) has been felt in many metal markets, it has not been proven that these are the cause of greater volatility.
Finally, greater price volatility in commodities markets has coincided with the spread of freely floating exchange rates. As China manoeuvres towards greater flexibility for the renminbi, this may contribute further to future periods of boom and bust.
Gruber, Joseph W. and Robert J. Vigfusson. Interest Rates and the Volatility and Correlation of Commodity Prices. Board of Governors of the Federal Reserve System. International Finance Discussion Papers. November 2012
Dwyer, Alexandra, George Gardner and Thomas Williams. Global Commodity Markets - Price Volatility and Financialisation. Reserve Bank of Australia. Bulletin June Quarter 2011.
Joets, Marc, Valerie Mignon and Tovonony Razafindrabe. Does the volatility of commodity prices reflect macroeconomic uncertainty? CIPII Working Paper. March 2015.
Jacks, David S. From Boom to Bust: A Typology of Real Commodity Prices in the Long Run. National Bureau of Economic Research. Working Paper. March 2013.
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