Yield surge punishes oil while gold sends out inflation feelers

Ole Hansen

Head of Commodity Strategy

Summary:  The month-long commodity rally has stalled and while the strong fundamental outlook for the sector hasn't suddenly turned on a dime, it is the ongoing surge in US Treasury yields that have forced a reduction in the general level of risk appetite across markets. Oil took a major hit from these development as fundamentals showed signs of short-term weakness. Gold meanwhile made an attempt to reestablish its reflation credentials


The month-long commodity rally has stalled and while the strong fundamental outlook for the sector hasn’t suddenly turned on a dime, it is the ongoing surge in US Treasury yields that have forced a reduction in the general level of risk appetite across markets. Led by a major, and some would argue long overdue, correction in crude oil, the Bloomberg Commodity index traded down by 3% to record its biggest weekly loss since October.

While individual developments within each commodity helped set the tone, the overall direction was for a third consecutive week being dictated by developments in the US bond markets. The steep sell-off on Thursday across commodities, stocks and bonds occurred after the dovish FOMC meeting failed to reassure the market on fears that yields and inflation will continue to rise. The Fed will basically allow both the economy and inflation to run as hot as they want to. In particular, the inflation comment about allowing it to run above 2% for a sustained period spooked the market.

The individual commodities most exposed to the latest round of risk adversity are those carrying the biggest speculative length. Overall, the commodity sector has enjoyed a strong revival in recent month for solid reasons that we have talked about at length in previous updates. Money managers or speculators have during the past nine months, as a result of strong price momentum, been accumulating a record commodity exposure, and with a few exceptions, one being gold, the net long across many have risen to the extent that a change in the short-term fundamental and/or technical outlook could trigger a sharp correction.

Crude oil which in recent weeks increasingly had been showing signs of having reached its short-term price potential, dropped the most since October after being given a double blow on Wednesday from the International Energy Agency and the FOMC. In their latest monthly Oil Market Report, the IEA raised questions about some of the reasons that have supported Brent crude oil’s recent surge to $70/b. Specifically, the risk of a new super-cycle and a looming shortfall were given the cold shoulder.

Not only do they see ample oil inventories despite a steady decline from the massive overhang that piled up during 2Q20. They also highlighted the hefty amount of spare production capacity, currently in the region of 8 million barrels/day that is being held back by OPEC+ members. With the recovery in fuel demand still fragile, especially as the vaccine rollout hits problems across several regions, most noticeably Europe, global demand growth forecasts around 5.5 million barrels/day in 2021 could end up being too optimistic.

With these developments in mind, it is clear that the 80% rally since early November, when the first vaccine news broke, has primarily been driven by OPEC+ withholding production. Thereby leaving the price exposed to any negative news related to demand. The floodgates opened once Brent broke below $66.50, and from there it was an almost a straight line drop down to $61.5. While these new lower levels better reflect the current oil market situation, the risk remains that speculators may not yet have fully adjusted their positions.

On the other hand, having fought so hard to support prices during the past year, OPEC+ members are unlikely to remain passive spectators should the price drop further. If it did we shall expect verbal intervention as the first line of defense, and if not enough, extend current cuts for longer or even cut more barrels. OPEC+ have plenty tools available and led by Saudi Arabia they have shown willingness to use them.

From a technical perspective Brent has broken the uptrend from November but so far found support at the 50-day SMA at $61.50, and a weekly close above would support risk sentiment and potentially signal a bounce over the coming days.

    Source: Saxo Group

    Gold received an initial boost after the FOMC confirmed its dovish stance by maintaining an outlook for unchanged rates until 2024. While effectively flashing a very accommodative green light for risky assets and dollar bears, the market instead took fright from the ongoing question of whether the Fed is making a “policy mistake” in seeing the rise in longer US yields as entirely benign.

    Furthermore, the market concluded that the Fed will accept both the economy and inflation to run wild, with the latter being allowed to rise and run above 2% for a prolonged period of time. While initially falling in sympathy with other asset classes, gold increasingly began attracting a bid as it tried to reestablish the reflation credentials that has been thoroughly missing for the past few months. Signs that it is having some success can be seen in the relation between gold and US 10-year real yields. On March 8, when the real yield traded at -0.6%, gold was challenging support at $1680, some 60 dollars below its current level.

    While other commodities, due to elevated positioning, such as oil and grains have been left exposed to risk reduction, gold was already unloved by investors. The lack of momentum in recent months had resulted in hedge funds reducing their net long in COMEX gold futures to a near two-year low at 42k lots (4.2 million ounces), an 85% reduction from the recent peak in February 2020.

    Total holdings in bullion-backed exchange-traded funds as reported by Bloomberg have seen continued reductions during the past 30 days, falling to a nine-month low at 3,144 tons, a 9% reduction from last year’s peak. One region, however, which has gone against the trend is in China where ETF holdings in February, according the World Gold Council, increased by 8 tons to a record 68.6 tons, after investors faced turmoil’s in the Chinese stock market.

    For now, gold remains stuck in no man’s land and despite having seen a slight improvement in the technical outlook, that’s where it remains. For that to change and in order to attract renewed demand, especially from leveraged accounts, it needs to retake $1765/oz and until it does we maintain a short-term neutral outlook, while maintaining a medium-term bullish belief in gold’s ability to recover back towards $2000/oz.

    Source: Saxo Group

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