Behind The Great 2008 Commodity Sell- Off

Commodity prices continue to fall.

Gold fell nearly 5 percent in early European trading on Friday. Oil prices have also slipped some more, a session low of under $113 a barrel was hit. Silver suffered the most in the sell-off of precious metals, with prices plummeting to a low of $12.39 an ounce, their weakest since last September.

Platinum and palladium slipped 7 percent and 6 percent respectively. Both have suffered significant losses in recent weeks.

The overall downtrend in the commodity markets in recent months can be seen in the performance of indices such as the Reuters-Jeffries/CRB index, which has fallen almost 18 percent since early July.

Meanwhile, the dollar extended its rally overnight, hitting a nearly 2-year high against the pound and gaining further against the euro.

What's going on?

There are four factors that may be contributing to the sell-off.

The first may be the likelihood that some of the sell-off is simply a normal technical pullback against the major trend. The commodities boom has been a multi-year boom, and thus a pullback was due at any time.

Second, the climb in commodities prices was so dramatic and long lasting that many economic actors, both consumers and producers, have had time to adjust and consider alternatives to paying higher prices and, thus, cutting back on demand.

Third, the possibility exists that some of the sell-off may be the result of hedge fund liquidations. There are continuing rumors that some hedge funds are in trouble, if so, the first things they may try to sell off to meet marginal calls and partner liquidations are various futures positions since the futures offer a very liquid market to sell into.

Fourth, the Federal Reserve over the last three months has dramatically reversed its huge money printing operation. Generally, it takes time for changes in money supply operations to impact the markets, but this change in Fed actions could impact sooner because of the enormity of the change. From double digit growth to growth in the last three months of under 3%.

To the degree that the current sell off is simply a technical pullback, it should be over soon with commodities moving higher, again.

To the degree that it is the result of economic actors adjusting their activities, the drop should soon be over and prices should stabilize at current levels.

To the degree hedge fund liquidations have been behind the decline, then as soon as the liquidations are over (and they could be over very soon), commodity prices will begin to climb again.

To fourth and final factor is most important for the long-term trend in commodities. If the Fed maintains the current low growth rate of money supply, then commodities have much farther to go on the downside as the United States will be in a deep recession--extended far behind the housing crisis.

If the Fed reverses ts low growth operations, and begins printing at double digit rates again, then this will fuel further advancements in commodities prices.

Finally, it should be noted that these factors are not mutually exclusive, and that more than one of these factors could be operating on commodities prices, sometimes in countervailing fashion.