Commodity weekly: Rising yields a short-term threat to the commodity bull run
Head of Commodity Strategy
Summary: Weekly commodity update focusing on the potential short-term negative impact on the sector from spiking bond yields. A development that has triggered higher volatility and with that the risk of deleveraging. Commodities have enjoyed several months of increased attention and the strong momentum across many individual raw materials have led to a speculative buying frenzy. While fundamentals point to further gains over the coming months, the short-term focus may turn to profit taking and deleveraging.
Commodities continue to witness increased attention and demand. Following a near decade of trading sideways to lower, it has embarked on a strong rally with individual commodities reaching multi-year highs. During the past decade we witnessed a period of strength among individual commodities but in recent months it has become noticeably more synchronized across all the three sectors: energy; metals; and agriculture.
However, following the spike in U.S. bond yields this past week, the sectors recent success in attracting record amounts of speculative buying may in the short-term, and despite strong fundamentals, force a correction or at best a period of consolidation. In this update we take a closer look at the reasons behind the rally and why yield moves matter.
There are plenty of reasons why commodities are on the move, but importantly there are expectations for a post-pandemic growth sprint with large amounts of stimulus driving demand for inflation hedges and green transformation themes. This is against a backdrop of the tightening supply of several key commodities following years of under investment. These developments increasingly drive expectations that we have entered a new dawn for commodities, raising the prospect for a new super cycle.
A super cycle is characterized by prolonged periods of mismatch between surging demand and inelastic supply. These supply and demand imbalances take time to correct due to high start-up capex for new projects, alongside the time needed to harness new supply. For example, in the copper industry it can be ten years from decision to production. Such periods often cause companies to postpone investment decisions awaiting rising prices, at which point it is often too late to avoid further price gains.
Previous demand-driven super cycles included rearmament before WW2, and the reform of the Chinese economy which accelerated following its accession to the WTO in 2001. Then, the period prior to the 2008 global financial crisis saw the Bloomberg Commodity Total Return index surged by 215%. Super cycles can also be supply driven with the most recent being the OPEC oil embargo of the 1970’s.
It is expected that the next commodity super cycle will not only be driven by recovering demand, but also heightened inflation risks at a time when investors will need real assets such as commodities to hedge their portfolios following years of sub-par returns. In addition, following a decade when investment in technology was preferred over hard assets there has been a lack of new supply lines.
Whereas the early November vaccine news coupled with Joe Biden’s winning of the US presidency helped boost the sector, its current rally is almost ten months old (see chart above). Launched last April at the peak of the Covid-19 pandemic's first wave, the initial rally was driven by producers cutting supplies while China embarked on a massive stimulus program to reignite their economy.
Fund positions in key commodities relative to the one-year minimum and maximums showing the extent to which long positions have risen in recent months. Especially within the agriculture and energy sectors.
Strong commodity momentum in recent months, alongside emerging signs of tighter supply, helped attract increased buying from speculators, some looking for inflation hedges while others simply jumped on board the momentum train. Whereas physical demand and tight supply look set to support prices over the coming months, if not years, the short-term outlook may become more challenging as “paper” investments have been exposed to the reduced risk appetite spreading from the recent rise in bond yields, most notably in real yields.
The emerging tightness across several commodities has, for the first time in seven years, helped create a positive carry on a basket of 26 commodity futures - a key development
While most of the rise is being driven by increased inflation expectations through higher break-even yields, rising bond yields are manageable. During the past few weeks however, the rise in nominal bond yields saw real yields increase faster. This is worrying for the stock market because valuations among many so-called bubble stocks, with strong momentum but no earnings, suddenly look frothy.
A period of risk reduction driven by falling equities and rising volatility may become the catalyst for consolidation across the commodity sector: caution is warranted during that time. We firmly believe that inflation will eventually rise by more than expected, thereby stabilizing, or perhaps even sending real yields deeper into negative territory. However, with many individual commodity positions at elevated levels, and RSI’s pointing towards overbought markets, the prospect for a correction, or at best a consolidation, will probably prove beneficial for medium-term prospects.
Finally, a word on gold, one of the commodities that has suffered the most in recent weeks but which potentially also could be one of the first to benefit from the latest bond yield spike. We have in updates and comments highlighted the risk that gold could suffer until bond yields rose to levels, that could force a response from the US Federal Reserve in terms of introducing measures to prevent longer dated yields from rising further.
During the past few months gold traded lower despite real yield’s staying close to -1%. That, however changed this week when 10-year real yields at one point spike to -0.55% without gold suffering a similar dramatic sell-off. These developments have brought yields and gold back in line. In the short-term, gold remains at risk of a deeper correction should it fail to stay above key support at around $1760/oz.
The copper-gold ratio against US 10-year nominal yields highlight clearly the recent disconnect between rising copper prices indication a return to growth while bond yields stayed low. Under normal circumstances we are now seeing the two get more in line. But these are not normal times and given the risk of a Fed intervening in order to curb yields from rising we could see a major realignment. Primarily from much higher gold prices as real yields would slump as inflation expectations continue to rise.