by Gino D’Alessio
by Gino D’AlessioCommodity Prices Related to China M1 Money Supply Growth
What is M1 Money Supply?
M1 Money Supply is all the money in circulation that is hard cash plus deposits. That is, the cash held on current & deposit accounts which is easily accessed and readily available. This is money that is frequently used and exchanges hands often. It may not necessarily be in bank notes, but it is available to be used as such. The balance on your bank account is not in hard cash, but all balances are effectively liquid money and considered under the definition of M1 Money Supply. This money is used to buy a series of goods that are commodity based, such as petrol, coffee, clothing and so on.
Why would Growth in China M1 be related to commodity prices?
China is one of the leading producers and consumers of most commodities, in particular, Metallurgical Coal, and Aluminium as well as many others. The country consumes approximately 75% of the world’s Metallurgical Coal. China is also by far the world’s largest cotton consumer, with 32.5 million bales consumed in 2015, the next largest consumer is India at 25 million bales. The country is also responsible for 50% to 100% of global increases in commodity consumption. An increase in M1 Growth is a predictor of the health of an economy and also indicates how much cash is on hand to be spent. It would make sense then as China is such a large consumer of many commodities that there would be a relationship between M1 Growth and commodity prices. M1 Growth is not just about how much spending power consumers have. Surging M1 growth should occur in expansionary economic phases, the increase in economic activity should, therefore, lead to an increase in the consumption of most commodities.
How to describe and define a “correlation”.
This type of relationship is referred to as correlation and is based on a scale from -1 to +1. The two extremes of the scale indicate perfect negative correlation, -1 and perfect positive correlation, +1. Perfect Positive Correlation means that the values of two data sets, or the prices of two assets, will move in the same direction at the same time. Perfect Negative correlation means the two values of the data sets will move in opposite directions all the time. A correlation of zero would indicate that the two values, or prices, move in an entirely random fashion with respect to each other.
Correlations & time lag
The commodity prices that had the highest positive correlation to China M1 Growth were; Global Metallurgical Coal, Global Cotton, and US Gasoline New York Harbour. Most other commodities had very small correlations, slightly above or below zero. However, all three commodities showed the correlations were highest after some time lag. That is to say, Commodity prices changed the most when a certain period of time had elapsed after changes in M1 Growth. Gasoline had the highest correlation at +0.851, using a lag of 3 months for Gasoline prices. Cotton was second, and this commodity had a correlation of +0.632 using a lag of 3 months for Cotton prices. Metallurgical Coal had a lower correlation at +0.448. However, this high correlation was achieved with a lag of 18 months in Coal price.
These correlations are extremely high, a correlation of +0.851 for Gasoline and M1 Growth means that 85.1% of the time Gasoline price should move in the same direction as China M1 growth, in this case with a lag of 3 months. This means that if in month 1 there is a surge in money supply growth then 3 months later there should also be an increase in gasoline price. Such a high correlation allows for some insight as to where certain commodity prices may be heading. Options traders should take heed.
Why the lag?
The lag in the relationship between commodity prices and M1 Growth may be due to the time it takes the economy to react to the change in growth of money supply. As the money supply increases at a faster rate, there should also be an expansion of the economy. However, the effects of economic expansion may not be felt as quickly by some commodities. Demand is one of the biggest factors in commodity price, but as demand increases it may take time for price to adjust, especially when stocks of the commodity are high. Therefore, before an increase in the price of commodities can be felt there has to be a period of sustained demand growth, eventually, stocks will begin to diminish, and commodity prices will begin to rise.
Traders looking to take advantage of these correlations need to ensure their broker offers longer term binary options. Many will not offer trades beyond 1 month (some even shorter). Long term options of up to a year are available with certain brokers, 10Trade and Binary.com offering the most flexibility. CFD brokers allow traders to hold a positions for as long they need, and Markets.com represents a good choice there.