Why Bond Bulls Need to Wake Up, Smell the Coffee

Anyone trying to sell you a bond nowadays will tell you that the recent jump in long-term interest rates is a false alarm, at least as far as inflation is concerned. There is no inflation to speak of, the bond bulls insist.

Unless, of course, you’re a coffee drinker. The price of a pound of coffee on futures markets has rocketed from 72 cents at the start of the year to $1.33 now--an 85% gain--as bean production has fallen drastically in South America and Africa.

As a result, Philip Morris Cos.’ General Foods division just announced that it is boosting the retail list price of a can of regular Maxwell House coffee from $2 to about $2.50, or 25%.

Commodities are the proverbial fly in the ointment of the no-inflation crowd this year. Though prices of crops, metals, wood products and other basic agricultural and industrial supplies are constantly in flux, their general direction has been unmistakably up lately.

The Commodity Research Bureau index of 21 key commodities rocketed on Monday to a 3 1/2-year high, causing a mini-panic in the bond market. On Tuesday, the CRB index fell back 1.5%, but it’s still up nearly 4% year-to-date.

The CRB index is heavily weighted toward grain prices, so it has been surging in recent weeks as fears about a dry Midwest spring (and already low inventories of key grains) have driven crop futures prices higher. Meanwhile, another commodity index--the Journal of Commerce Industrial index, which tracks prices of metals such as aluminum and zinc--also has been advancing strongly.

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So far, rising commodity costs aren’t translating into a higher consumer price index, the most closely watched inflation index. The bond bulls argue that commodities’ rally is a mere blip, and that the world economy isn’t strong enough to support higher raw materials prices, let alone higher prices for finished goods.

Some contend commodities’ recent gains are the work of professional traders, not the result of “real” demand. There may be some truth to that. Caroline Van, analyst at hedge-fund tracker International Advisory Group in Nashville, says her firm is increasingly hearing from big investors who want to place money with hedge funds that trade in commodities. “They’re interested in commodities as a (new) asset class,” Van says.

In Santa Monica, well-known hedge fund manager Mark Strome believes metals such as copper, nickel and aluminum are poised for dramatic price rises. “I think this is the opportunity” in financial markets in ‘94, he says.

But for metals prices to surge, Strome concedes, real demand--from busier factories churning out more goods--will have to be there worldwide.

Robert Genetski, who runs a Chicago-based economic advisory firm bearing his name, predicts that the No. 1 surprise this year will be a stronger U.S. economy than Wall Street now foresees. The Federal Reserve Board, Genetski argues, allowed money to be so loose for so long (1991 to 1993) that the seeds of robust future business and consumer spending are already sown.

While the conventional wisdom is that the Fed’s credit-tightening moves this year will slow the economy, Genetski points to the surge in bank loan demand from business borrowers in recent months as evidence that the economic expansion is gaining steam, not losing it. Commercial and industrial loans outstanding, which plunged from 1991 through ‘93, have jumped to $605 billion now from $585 billion at Jan. 1, even as rates have increased.

Higher demand for goods and services--not just in America, but also now in recovering Europe--is what’s behind the upward pressure on prices of many once-glutted commodities, Genetski says. As those higher prices stick, and work their way into the cost of products at retail (like coffee), he believes the 2% to 3% inflation of recent years will turn into 5% inflation in 1995 and 6% in 1996.

What about global competition and rising productivity? Those influences ought to suppress price increases, says investment strategist Katherine Hensel at Lehman Bros. in New York. Plus, she notes that raw materials generally account for only one-third of manufacturing costs; labor is two-thirds, and there’s certainly no shortage of labor around the world, she adds.

Still, Genetski and other economy-bulls say the strength in commodities this year is the inflation bell tolling--softly so far, but unmistakable.