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Can the grains stay strong?

10/01/2010 @ 8:38am

If the third quarter was a dream, commodity fund managers may not want to wake up.

From wheat to tin to gold, commodities took turns to shine on the back of a host of factors ranging from damaged crops in Russia to strong demand from China to fears of further monetary easing.

"We had a unique storm," said Mihir Worah, who runs the $18 billion Pimco Commodity Real Return Strategy fund, the largest commodity mutual fund that tracks the Dow Jones-UBS Commodity Index.

That benchmark index posted its best-performing quarter since June 2009, up 11.6%. Mr. Worah's fund beat that in the third quarter, returning about 14.5% amid a broad-based rally in commodities.

Looking ahead, commodities are in for "interesting test" during the final quarter, said Kevin Norrish, managing director of commodities research at Barclays Capital.

While low interest rates will continue to support commodities, some of the engines behind the third-quarter rally are likely to fade, such as the extreme weather events and supply shocks in the agricultural market.

A wild card for commodities is whether the policies implemented by the central banks will be able to revive the economies and generate demand -- an ultimate engine for commodities.

In September, Japan's central bank intervened in the currency market to weaken the yen, while the Federal Reserve decided to maintain interest rates at historically low levels.

Mr. Worah considers the state of currencies to be the biggest driver for commodities. "Central banks and policy makers globally are looking for a weaker currency" in order to fuel the economic recovery, he said. If these policies don't work, "it's somewhat bearish for commodities."

Agriculture

Wheat set the stage for the third-quarter rally in commodities. Prices started to move up in June, as a severe drought and raging wildfires in Russia raised concerns about lowered production in the third-largest exporter of wheat.

When the Russian government imposed a temporary ban on wheat exports in August, prices shot through the roof. Wheat ended the quarter with an astonishing gain of 45%, the best in three years.

The wheat spike soon spread to other agricultural markets, such as corn and soybeans, due to concerns of a potential food shortage. Prices for corn and soybeans rose 39.9% and 16.7%, respectively.

Besides staples, the so-called soft commodities such as sugar, cotton and orange juice also soared on weather-related supply disruptions.

Brazil's dry weather sent sugar prices up 40.3% to a seven-month high; in Pakistan, the worst flooding in decades destroyed the nation's cotton belts and jacked up cotton prices to exceed the $1 mark; a series of hurricane scares jolted the orange-juice market with prices hitting a three-year high.

Also on commodity traders' radars will be the global weather trend in the following months.

"We happened to be in the grips of a very strong La Nina year," in which cooler-than-normal temperatures in the Pacific Ocean lead to extreme weather events such as drought and flooding, said Michael Ferrari, vice president of Commodity Research Weather Trends.

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