Head of Commodity Strategy
Summary: Commodities suffered a sharp reversal during the past week with losses seen across all sectors except grains. The weakness was triggered by the relentless surge in US bond yields, supported by another strong US job report, and a stronger dollar raising growth and demand concerns for crude oil and fuel products, as well as industrial metals, while creating a challenging environment for investment metals.
This past week we published our Q4 2023 Outlook titled “Bond. Long Bond(s) in which we look at how an economic slowdown and ‘peak rates’ could push us toward a stagflation lite environment and with that a four-decade opportunity to go long bonds. In the commodity section, we argue that such a development would also likely support investment metals, especially gold which, despite current headwinds from rising yields and a stronger dollar, continues to benefit from central bank demand.
The Bloomberg Commodity Total Return Index suffered a sharp reversal during the past week with losses seen across all sectors except grains. The weakness was triggered by the relentless surge in US bond yields, supported by another strong US job report, and a stronger dollar raising growth and demand concerns for crude oil and fuel products, as well as industrial metals, while creating a challenging environment for investment metals. Overall, the index traded down 2.7% on the week with losses being led by an 11.5% slump in diesel and the biggest weekly drop in crude oil since March. The grains sector meanwhile showed signs of stabilizing with wheat futures recovering from a three-year low amid signs of renewed demand forcing funds to reduce an extended short position.
There has been a lot of talk recently about the US yield curve, the so-called bear-steepening move, and what this signals. Since early July, the US 2-10 yield curve spread has steepened from a very inverted level around -110 basis points to the current -27 basis points. The latest steepening has been driven by a faster increase in the 10-year yield to a 16-year high near 4.85%, while the 2-year yield has risen to 5.12% amid doubts about how much higher the FOMC will be able to raise rates without damaging the economy.
Bear steepening does not only raise red flags for stock market investors but also the wider economy. Rising long-dated yields have a large and rapid tightening effect on the real economy given the impact on private mortgage rates and corporate borrowing rates. In a situation where the economy is running hot, rising interest rates pose limited risks as rising yields are a normal reaction to robust growth. However, in the current situation where sticky inflation is driving long-end yields higher, it may pose a threat as the economic outlook looks increasingly challenged and could deteriorate faster.
The energy complex, excluding natural gas, saw a long overdue correction turn into an aggressive slump as surging bond yields and the stronger dollar accelerated demand worries. Not least after the EIA reported a slump in the four-week average of implied gasoline demand to the lowest level in 25 years for this time of year. The market took this as a clear sign that fuel demand has been hit by near-record pump prices. Yet, as highlighted in this tweet, the reduction was partly explained by station owners backing off on buying a full tanker of gasoline in anticipation of a further drop in prices.
The combination of stabilizing crude stocks at Cushing – the WTI delivery hub – sharply higher gasoline inventories, this slump in implied demand, and Russia announcing an end to its short-lived export ban on diesel all helped send refinery margins, or cracks, down by more than one-quarter on the week, thereby alleviating some of the inflationary pressures that had been building during the past couple of months and which helped turbocharge the selloff in global bond markets.
The slump in crude oil prices was led by WTI, down 9.5% on the week, and apart from the developments in the US market, positioning from speculators has also played a key role as an accelerator of the sudden price weakness. Commitment of Traders data, provided by the US Commodity Futures Trading Commission (CFTC) every Friday with data from the week ending the previous Tuesday breaks down the open interest across futures markets in separate groups of users.
In commodities, we focus primarily on the managed money group, as this group of traders – which includes hedge funds and Commodity Trading Advisors (CTAs) – tends to anticipate, accelerate, and amplify price changes that have been set in motion by fundamentals, like the current production cuts from Saudi Arabia and Russia. However, being followers of momentum, this strategy often sees this group of traders buy into strength and sell into weakness, meaning they are often found holding the biggest long position near the peak of a cycle or the biggest short position ahead of a through in the market.
In the latest reporting week to Tuesday, September 26, money managers had accumulated a gross long of 336 million barrels while the gross short had been reduced to just 21.4 million. The result being a long/short ratio at 15.7, well above the five-year average around 6.7, leaving the longs with a narrow exit door through which they have been scrambling to squeeze through this past week. Saudi Arabia’s attempt to squeeze and hurt short sellers has been so successful that it has now temporarily backfired as longs are forced to reduce exposure into a market with a limited amount of short positions to cushion the fall.
Having returned to levels seen before last month’s announcement from Saudi Arabia and Russia regarding a production cut extension to yearend, the prospect for further price declines in our opinion looks limited. Having already overshot to the downside amid selling pressure from long liquidation, the short-term direction will likely depend on the general level of risk appetite with the market focusing on US jobs and inflation reports, and their impact on bonds and not least the dollar.
Following a brief spike above $93.75 resistance last week, the WTI futures contract has turned sharply lower, in the process suffering a 13.5% decline while slicing through several layers of support. Traders are selling in response to demand concerns but having fought so hard to support the price, and in the process giving up revenues, Saudi Arabia and its Middle East neighbors are unlikely to accept much lower prices. This leads us to believe support in WTI and Brent will be established ahead of $80. The upside for now seems equally limited while the bear steepening of the US yield curve continues to raise stagflation concerns, and with that in mind Brent may once again settle into a mid-80’s to $90 range, an area we would categorize as being a sweet spot, not too cold for producers and not too hot for consumers.
In our latest weekly update, we mentioned how the precious metal sector had finally succumbed to the negative impact of sharply higher bond yields and the stronger dollar. The weakness accelerated this past week with silver and platinum both taking a +6% tumble while the losses in gold were limited to less than 2%.
Looking at the recent rally in bond yields and the dollar, it is difficult to build a bullish case for gold if current developments were the only driver for the yellow metal. However, we do note that while the bear steepening of the US yield curve is weighing on some assets, the recessionary signal it is sending will, if sustained, eventually bring support back to gold, not least from a change in the outlook for short-term rates where the market is still only looking for around three (25 bps) rate cuts during 2024.
In addition, demand for gold as a hedge against a soft-landing failure is likely to strengthen as the outlook for the US economic outlook in the months ahead looks increasingly challenged. With that in mind, we maintain a patiently bullish view on gold with the timing for a fresh push to the upside being very dependent on US economic data as we wait for the FOMC to turn its focus from rate hikes to cuts, and during this time, as seen during the past quarter, we are likely to see continued choppy trade action.
For now, the current cost of holding a gold position for 12 months is close to 5.8%, the bulk of that being the cost of borrowing dollars for one year. Until we see a clear trend towards lower funding rates and/or an upside break forcing a response, real money allocators will be looking for opportunities elsewhere. ETF investors, which include the above mentioned group of real money allocators, have been cutting holdings for the past four months, leaving the total down by 7% during this time to 2717 tons, a +3-1/2-year low.
Central bank buying has, just like last year, been providing a soft floor under the gold market, preventing the price from falling to levels that would otherwise be expected based on the recent bond yield and dollar strength. Silver, meanwhile, is currently hanging on a cliff edge having seen the technical outlook deteriorate, and with gold being supported by central bank demand, silver has been left to take to the full impact of rising bond yields, a stronger dollar and lower industrial metal prices in general. However, based on our outlook for a peak in US rates and stagflation risks, we see the potential for a strong rebound, but first we need to see the dollar, yields and copper stabilise.
From a technical standpoint, gold is showing signs of stabilizing with the US job report and next week’s inflation print both a major focus. The price of spot gold is holding above support at $1805, the February low, and $1787, the 61.8% retracement of the November 2022 to May 2023 rally.
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