What's Behind All of The Sell-Offs in Commodities?

It's always hard to decipher a root cause behind a particular price move in commodities because generally there are multiple contributing factors. However, in the commodities markets over the last two trading days, the price action can mostly be attributed to one key factor.

Analysts are pointing to rumors that Cyprus will need to sell its gold as a cause of the sell-off. However, if this were true, why would it affect other commodities like oil? And if it were due to weaker growth projections in the U.S., why have equities held up so well and why didn't gold rally on hopes of more central bank easing?

The true culprit has to be the one word that makes economists shiver in their boots, the one economic situation that forces the proverbial hands of central bankers. The true cause has to be deflation (or at least its less scary cousin disinflation).

Looking at market expectations of 2-year inflation as priced in by the market, or the 2-year break even rate of inflation, inflation expectations have fallen from 2.39 percent over the next two years to a mere 1.81 percent currently. This drop also occurred only over the last month, meaning that just in the last month, inflation expectations have fallen drastically.

Historically, just below these levels, the Federal Reserve has acted. In 2008, when inflation expectations fell this low, the Fed launched QE1; in 2010 when it happened, they launched QE2; Operation Twist followed in 2011 and its second iteration in 2012; and again, QE3 later that year.

If inflation expectations fall below this 1.75 percent level again, it could mean that fears of reduced QE from the Federal Reserve are way overdone. In fact, it could be a sign that the Fed could recommit to its current policy or even step on the gas pedal even more and expand the size of the monthly purchases. Either way, the data is a clear sign that the Fed will not take away the punch bowl any time soon.

Deflation is a scary sign for economies as it generally accompanies depressions or at the least deep recessions. What we are witnessing is probably more along the lines of disinflation, the situation where the rate of change of inflation (the percent annual change) is falling. This scenario can lead to deflation if it is not dealt with.

Looking forwards, Federal Reserve members are expected to speak this week including Vice Chairman Janet Yellen and Governors Stein and Raskin. Look for comments about lower inflation and growth and further easing as signs that the Fed is taking notice and could change its policy stance at the next meeting.

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