Real yields a boon to tightening commodity markets

Real yields a boon to tightening commodity markets

Ole Hansen
Head of Commodity Strategy

Summary:  The growth trajectory might slow a little, but the commodity rally is far from being out of fuel

After what has already been a strong year for commodities, we maintain a bullish outlook into Q4 and beyond. The strong rally seen across many key commodities this year has been driven by surging consumer spending following the Covid-led economic contraction—the biggest in living memory. As the impact of government spending and handouts from governments in Europe, China and the US begins to taper off, the market has started to cool a bit. However, supply constraints will, in our opinion, continue to support prices despite a slower growth trajectory.

Ahead of the final quarter of 2021, the Bloomberg commodity index—which tracks a basket of major commodity futures evenly split across energy, metals and agriculture—had risen by 25%, with gains seen across all sectors except precious metals. Later in this outlook we take a look at the reasons why gold, the most interest rate and dollar–sensitive of all commodities, has struggled to rally despite what should have been strong tailwinds from near-record low negative real yields.

First though, we need to take a closer look at the European power and gas markets. During September they surged to reach prices more than four times higher than the long-term average. At the time of writing Dutch gas—the European benchmark—was trading up 250% on the year, while German power and coal prices were both up by around 150%. These three markets, together with an also surging European emissions price, are not part of the mentioned index, which otherwise would have been higher than the ten-year high reached in September. 

Source: Bloomberg Commodity Subindices, Saxo Group

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Surging gas and power prices have also been felt outside Europe with hot weather–related demand not being met by a similar response from producers. Add to this the worst quarter for wind power generation in years, and the pressure on traditional fuels such as gas and even coal has been elevated. As a result we are heading into the northern hemisphere winter with stock levels, both in the US and especially in Europe, well below the average seen in recent years. If not arrested by a milder than normal winter or increased flows, either from LNG or from Russia through the soon-to-open Nord Stream 2 pipeline, a bleak—and expensive—winter could await Europe’s consumers and energy-heavy industries. 

Agriculture sector: Following a very volatile planting and growing season troubled by adverse weather across the world, the agriculture sector should see more settled markets in Q4. However, with the UN FAO Global Food Price Index rising at an annual rate of 33%, the sector needs a period of normal weather in order for producers to rebuild stock levels. With that in mind the focus now turns to South America as they enter their growing season for key commodities from soybeans and corn to sugar and coffee. 

Energy: We see the Brent crude oil price range shift higher by five dollars from the mid-60s to mid-70s that we forecast, and which prevailed throughout most of the third quarter. With crude oil settling into a range following the dramatic first half surge, the reflation trade also started to deflate, thereby reducing investor appetite for commodities. The fading momentum and return to rangebound trading helped drive a 23% reduction in the combined net long futures position held by funds in WTI and Brent. 

With more optimistic Covid-19 developments expected into the year end, the IEA sees global oil demand rebound by 1.6 million barrels/day in October and continue to grow into the year end. Add to this the loss of more than 30 million barrels of production during the US hurricane season, along with the risk of failure to reach a nuclear deal with Iran, and the OPEC+ group of producers are likely to continue to support a gradual price increase by keeping monthly production increases at a steady pace of around 400,000 barrels per day. 

Just as the reflation trade deflated as oil settled into a range, the prospect for higher prices into the year end and beyond could be the trigger needed to re-establish that focus, thereby supporting reflation darlings such as copper, and potentially even gold.  

Industrial metals remain a key part of the decarbonisation process, and despite signs of slowing growth in China, the world may still be facing a decade where the physical world is too small for the aspiration and visions of our politicians and environmental movements. The more we decarbonise under the present model, the more we ‘metallise’ the economy. The supply chains, meanwhile, are inelastic due to a lack of support for permitting, board approval and a lack of capital flowing into the “dirty” production side of the equation due to ESG priorities.

With this in mind and given China’s ongoing efforts to cut pollution by curbing the output of several high-polluting metals from steel and two of the so-called green metals, aluminium and nickel, we continue to see underlying strength resulting in higher prices for ‘green’ metal, a group that—besides the two mentioned—also includes copper, tin, silver, platinum, lithium, cobalt and several rare earths. 

Copper’s surge to a record high earlier this year was, to a certain extent, being driven by the reflation trade. Until it deflated during the third quarter this had provided a key source of support. While supply constraints lifted nickel and aluminium, copper is waiting for a renewed and strong pick-up in both physical and investment demand, with the speculative length the leanest it has been in more than a year. A break back above $10,000 would likely be the signal that triggers a fresh move towards new all-time highs. We believe that journey will resume sometime during the final quarter. 

The effects of negative real rates on commodity prices: Real interest rates are an important influence on commodity prices. Low interest rates tend to increase the price of storable commodities through lowering the cost of carrying inventories and by encouraging increased speculative investment, as the opportunity cost of holding non interest or coupon paying commodities are non-existent in a negative real yield environment. Also investing in bonds in times when inflation surpasses the bond yields do not protect the purchasing power of the investor. This. combined with emerging tightness following years of plenty, have created a major incentive for investors to diversify some of their portfolio towards commodities and away from debt instruments. 

Source: Bloomberg and Saxo Group

Precious metals led by gold remain stuck in a range that by now has prevailed for more than a year. Besides silver’s unsuccessful attempt to break above $30 during Q1, both metals have been stuck in ranges, with gold currently struggling to find a way out of its 200-dollar-wide range between $1700 and $1900. During the past quarter one of the interesting developments was gold’s inability to shine despite a renewed drop in Treasury yields, not least ten-year real yields which at one point hit a record low at -1.2%. 

Gold’s inverse correlation with real interest rates has been well documented, and can be seen in the chart. Along with the ebb and flow of the dollar and the general level of risk appetite, we have some of the key components which determine the direction of gold. With strong risk appetite being a constant throughout the year, at least up until August, gold’s value as a diversifier diminished. With central banks successfully selling the transitory message about inflation, demand from financial investors in so-called “paper” gold such as futures, ETF’s and swaps began to fade. 

Highlighting this, fund managers has been viewing nominal rate risks as greater than the tail risks of inflation, not least in response to raised expectations of an accelerated tapering timeline being presented by the US Federal Reserve. Underlying consumer demand meanwhile remains strong in the major physical centres in India and China, while many central banks increasingly are using gold to diversify their FX reserves. Given the July dislocation between gold and real yields we argue that, provided there’s no major change in the dollar, the yellow metal should be able to withstand a 20–25 basis rise in the ten-year real yield from current historic low levels. 

Source: Bloomberg and Saxo Group

We maintain the view that the rising cost of everything will keep inflation levels elevated for longer, and with peak growth possibly already behind us, the outlook for equities looks more challenging. Add to this the prospect of less aggressive central bank action, and the foundation for another period of safe-haven and diversification demand could emerge. Gold needs to break above $1835 to reconnect with investors, and once it does this the signal for a return to an all-time high will have been given. 

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