High Food Prices? Blame Wall Street

It's not your imagination -- food prices are going through the roof.

According to the United Nations, the average price of food has increased a staggering 77% since the beginning of 2006. What used to be a $50 trip to the grocery store six years ago will now set you back $89.

Source: Food and Agriculture Organization of the United Nations.

We've been told that this increase is a result of three factors: heightened demand from developing countries like China, the use of corn and other products to produce ethanol, and the increased price of fossil fuels. High food prices, in other words, are simply a consequence of supply and demand -- the benign and unbiased forces of capitalism.

The problem with this explanation is that it's incomplete and misleading. While those factors do influence the price of food, they have also been seized upon by interested parties to mask a more powerful and pernicious force behind the skyrocketing trend: Wall Street.

When the market set food's price
The commodity futures market has operated in relative obscurity for much of its existence, familiar only to a small group of producers, consumers, and traders centered in Chicago.

Farmers and other producers use it to sell futures contracts at the beginning of planting season to hedge against a decline in crop prices prior to harvest. Consumers like restaurant chains and supermarkets -- think McDonald's (NYSE: MCD  ) and Whole Foods (Nasdaq: WFM  ) , among others -- buy contracts at the same time to hedge against the risk that prices will increase. And traders act as intermediaries by buying contracts from producers and then reselling them to consumers for a profit.

The size of the futures exchange has accordingly always paled in comparison to the size of the world's equity and bond markets. In 2004 and 2005, for instance, the latter accounted for $43.6 trillion and $54.3 trillion in market capitalization, respectively. Meanwhile, the futures exchange was only $183 billion in size, less than 0.2% of the other two combined.

Given the nature of the market participants, prices of commodities have traditionally tracked the supply and demand of the underlying products. Excluding the last few years, for instance, the price of corn only accelerated when there was a supply shock: The abrupt spike in 1988 corresponds to one of the worst droughts in U.S. history, and the massive spike in the mid-1990s corresponds to disastrous crop failures in China.

Source: U.S. Department of Agriculture; Feed Grains Database.

In addition, commodity prices were rarely positively correlated with each other. If the price of corn was high one year, farmers would plant more of it and less of, say, soybeans the following year. The resulting increase in the supply of corn would drive its price down, whereas the decrease in the supply of soybeans would drive its price up. This give-and-take pattern ensured that there would never be a sustained deficit of one crop or another, providing a near-textbook example of the virtues of a free market.

And then Wall Street intervened...
The financial wizards of Wall Street paid scant attention to the commodity futures market prior to the turn of the 20th century. Its measly size made it appear unworthy of their consideration. And even if it had been sufficiently large, many of the financial industry's most lucrative clients -- institutional investors -- preferred to avoid investing in it anyway.

All of this changed with the confluence of three developments in the early 2000s. First, institutional investors developed an appetite to diversify away from equities after suffering through the tech bubble, the 9/11 attacks, an ensuing recession, and the Enron and Worldcom debacles. Second, and at about the same time, a series of academic papers discovered that commodity returns inversely correlated to equity returns. And finally, spurred on by these developments, financial institutions like Goldman Sachs (NYSE: GS  ) , American International Group (NYSE: AIG  ) , and UBS (NYSE: UBS  ) constructed indexes that made it easier to track and invest in commodity futures.

The two most popular indexes are the Standard & Poor's Goldman Sachs Commodity Index and the Dow-Jones UBS Commodity Index. The first tracks 24 commodities weighted according to worldwide production value and is thus heavily influenced by energy products. The second tracks 19 commodities, 18 of which it shares with the S&P-GSCI, weighted according to worldwide production and liquidity factors.

Component

S&P-GSCI Weighting

DJ-UBS Weighting

Energy 70.5% 32.6%
Industrial metals 6.6% 18.6%
Precious metals 3.3% 12.6%
Agriculture 14.7% 30.4%
Livestock 4.7% 5.8%

Sources: S&P GSCI Fact Sheet and DJ-UBS CI Handbook.

To provide actual exposure to these indexes -- since you can't invest in an index itself -- investment banks used swaps, the now-infamous derivatives that crippled the financial system in 2008.

In a typical commodity swap agreement, an institutional investor agrees to pay the three-month Treasury-bill rate plus a management fee to a Wall Street bank, and the bank agrees to pay the total return on either the S&P-GSCI or the DJ-UBS. To hedge their positions, investors can invest the notional amount of the swap in three-month Treasury bills, while the banks can invest in futures contracts that replicate the targeted index.

The capital that flowed into the commodities futures market as a result of these agreements resembled a veritable tsunami. The total open interest of the 25 commodities included in the S&P-GSCI and DJ-UBS indexes went from $183 billion in 2004 to $356 billion by 2008. For comparison, this would be equivalent to flooding $12 trillion into the S&P 500. Not surprisingly, in turn, the increased demand for futures contracts corresponded with the dramatic increase in their price. And as you can see below, to stick with corn as a representative example, institutional ownership is now a leading indicator of its price.

Sources: Commodity Futures Trading Commission and U.S. Department of Agriculture.

Wall Street and the price of food
At the end of the day, there's no question that factors like ethanol production influence the price of commodities and, thereby, food. At the same time, however, a bigger and less benign force is at work. Indeed, it evidently wasn't enough that investment bankers and their ilk on Wall Street crashed our credit system and contributed to the artificial creation and subsequent destruction of trillions of dollars of home equity. They've now taken it upon themselves to manipulate and control the world's supply of food.

Fool contributor John Maxfield does not have a financial stake in any of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of  Goldman Sachs, McDonald's, and Whole Foods Market. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (7) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 30, 2012, at 4:11 PM, Jingles45840 wrote:

    And lets not forget the effect of "easing" on the declining value of the dollar where commodities are priced.

  • Report this Comment On May 30, 2012, at 6:54 PM, TMFGortok wrote:

    I'm quite surprised at the tone of this article, especially the end of it:

    "Indeed, it evidently wasn't enough that investment bankers and their ilk on Wall Street crashed our credit system and contributed to the artificial creation and subsequent destruction of trillions of dollars of home equity. They've now taken it upon themselves to manipulate and control the world's supply of food."

    So the investment community are the ones that held interest rates at historical lows that ended up flooding the market with cheap money? They're the ones that encouraged an 'ownership society' through an aggressive housing policy and created GSEs that had implicit guarantees that their risky loans would be honored?

    Of course they weren't. They were the ones that invested poorly *because* of the cheap money supplied by the Federal Reserve. They are the ones that, when their bad bets came back to bite them in the rear end, were able to get a bailout from their friends who created this mess.

    Artificially low interest rates flood the market with cheap money. When the money is so cheap, it's really easy (read: certain) that its use will result in malinvestment. When that malinvestment is uncovered, the only reasonable course of action is for the bad debt to be liquidated; otherwise you simply prop up bad debt with more bad debt, stacking the house of cards even higher.

    And that's what you're seeing here. The Federal Reserve has expanded its balance sheet by leaps and bounds. It has engaged in Quantitative Easing (read: Printing money) in sums never even before imagined. It's no surprise that money printing is going to cause inflation -- and where better to start than commodities -- something that everyone needs (otherwise they wouldn't be called commodities).

    What you're seeing is a few things: Investors flocking towards commodities; inflation helping to push the cost of those commodities higher, and sadly, economic policies that are near lunacy.

    To point the finger at the effect and call in the 'cause' is just not fair. Let's beat up on Wall Street for being in bed with government. Let's beat up on government for picking winners and losers, but let's not beat up on Wall Street for merely following the effects of bad economic policy.

  • Report this Comment On May 30, 2012, at 7:03 PM, TMFMorgan wrote:

    <<They were the ones that invested poorly *because* of the cheap money supplied by the Federal Reserve>>

    No one forces anyone to invest in anything. I had access to cheap mortgages in 2004, too. I made a decision to pass. I could buy inflated Treasuries today. I choose to pass. Anyone else could have, and still can, as well.

  • Report this Comment On May 31, 2012, at 6:10 AM, CaptainWidget wrote:

    Your theory should be easy to test. There are foods, in the US, that are barred from the commodities market by criminal punishment.

    If your theory is true, those foods should have smoother and lower prices. If your theory is false, those foods prices will be higher and more volatile.

    I know the answer to this one. Does anyone else??? Specifically...the author of this article......

  • Report this Comment On May 31, 2012, at 7:35 AM, TMFGortok wrote:

    @TMFMorgan I'm glad you brought that up. Your response though is the response of someone on the wrong end of the funnel. Wall street people (as individuals) may or may not have actually taken out mortgages for their houses. But what Wall Street did do as a whole is find ways to make money off of the cheap money, and they found mortgage backed securities and credit default swaps -- things that the general public does not have access to.

    You're right, no one 'forces' (in that there is no gun put to anyone's head that says, "You must invest.") them to invest. However, I submit that the Federal Reserve's actions are very close to that, here's why:

    The Federal Reserve controls the value of the dollar. They print more, the dollar is worth less (simplified for our discussion). The print less, the dollar is worth more (and consequently, the national Debt costs more to service)

    If interest rates are at 0.25% (or any rate below what the market would set without government interference), then anyone who saves money (does not invest it) is losing money. Even if the stated rate of inflation is only 2%, they're still losing 1.75% of every dollar that they are saving.

    So, they do what anyone else would do in their situation (And indeed, even what The Motley Fool seems to suggest writ large): They invest it.

    Why would they invest in treasuries? They know the rate of inflation is higher than the return they get on T-bills (and the actual rate of inflation being higher than the stated rate makes my point even more so), so they go to something else. Some 'smart' banker comes up with the idea of engaging in credit default swaps as a way to increase their return. Or, they decide to securitize mortgages, chop those up and sell them. They aren't stupid people, they see the writing on the wall, they just happen to be at the top of the funnel, and they make sizable donations to their favorite political cause.

    You may say, "Well if we just had tighter regulations, none of this would have happened!" I submit (and the Austrian Business Cycle theory says) that it would have simply happened in whatever sector was least regulated, or whatever sector the government made easiest to invest in through its policies.

    Without the cheap credit created by the Federal Reserve, we could not have had such a bubble and bust. Where would they have gotten their money from?

  • Report this Comment On May 31, 2012, at 10:03 AM, TMFMorgan wrote:

    Gortok,

    So, it's rational for them to invest in subprime bonds that will quickly lose 99% of their value versus, say, a money-market fund that will erode at 1% a year to inflation? That's the smart thing for them to do?

    People make this argument all the time, and I just find it nonsense. Investors' should maximize their return potential given the circumstances around them. Reaching for an extra 1% yield that eventually results in 99% loss of capital doesn't fit that bill. A 99% loss is greater than a 5% loss. "The Fed keeps interest rates too low" is not an excuse to blow your money down the drain.

  • Report this Comment On May 31, 2012, at 10:07 AM, TMFMorgan wrote:

    Also, when you write, "Why would they invest in Treasuries?" ... I don't know, but they do. Household ownership of Treasuries exploded by $800 billion over the last few years:

    http://research.stlouisfed.org/fred2/data/TSABSHNO_Max_630_3...

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