Head of Commodity Strategy
The combination of renewed dollar strength, a Saudi/Russia proposal to raise oil production, the increased risk of a US/China trade war, and improved crop conditions in the US all helped trigger a third consecutive week of losses for the broad-based Bloomberg Commodity Index.
Silver, natural gas, and WTI crude oil were among the few winners while losses were led by aluminium, copper and the three major crops. Gold stayed glued to $1,300/oz. as it put up a strong fight against the rising dollar while rallying the most since September against the euro.
The grains sector suffered a major setback with the worst price slump in almost two years being led by soybeans which hit a one-year low. The risk of a slowdown in foreign demand should China and Mexico retaliate against US tariffs hit a market already reeling from improved US weather conditions and fund long liquidation.
Copper led the industrial metals lower on a combination of dollar strength, the risk of a trade war, and recent data pointing towards weaker growth in China.
As expected the US Federal Open Market Committee hiked rates for a seventh time in this cycle while the European Central Bank saw rates unchanged through next year. The result of these announcements combined with political tensions within the government coalition in Germany helped support the best week for the dollar since 2016 while creating additional headwinds for most commodities.
A stronger dollar combined with rising funding and fuel costs – and now the risk of trade wars between some of the world’s biggest economies – seems likely to continue to create challenges. This is not only true for developed economies but also emerging market economies, especially those carrying a heavy debt load in dollars.
What we are currently witnessing carries the risk of lowering the outlook for global growth and demand over the coming quarters. This past week saw retail sales, industrial production, and credit growth from China come in weaker than expected as the country continues to show signs of slowing down.
The Citi Economic Surprise Indices, which measure data surprises relative to market expectations, shows the recent deterioration in economic data from key economies.
Gold had a relatively strong week, which sounds strange to some considering it stayed glued to $1,300/oz. after failing to break higher following the dovish call on rates from European Central bank head Mario Draghi. The negative correlation to the dollar should have seen XAUUSD trade sharply lower, but with the dollar strength being more about euro weakness the real action was seen in XAUEUR which rallied by more than 2% to record its best day since last September.
Following Trump’s meeting with North Korean leader Kim Jong-un in Singapore last week (which was high on promises and low on substance), geopolitical risks are at risk of rising again. This after the US administration has moved ahead with its plan to slap tariffs on $50 billion worth of Chinese goods.
Despite the dollar rally clearly not yet showing any signs of having run out of steam we continue to see the potential for gold turning more supportive. The US yield curve is likely to continue to flatten as short-term yields rise while long-end prices stay supported due to the aforementioned worries about trade wars and EM. Even if bond yields move higher, rising inflation expectations may keep real yields rangebound as breakevens move higher.
Paper investments have faded with hedge funds’ position (before this week’s action), being near a two-year low while total holdings in exchange-traded funds backed by gold have dropped after reaching a five-year high last month.
These observations are all pointing towards a move in gold and while the downside may still be in play below $1,286/oz. the low level of hedge fund participation makes us believe that the direction that could receive most momentum would be to the upside. For now, the stronger dollar presents a challenge but the lack of weakness does highlight the risk of an upside move. In order for this to play out, a sustained break above the 200-day moving average at $1,308/oz. is needed to get investors off the fence and back into the market.
Crude oil remains stuck in a relatively tight range in the run up to key meetings in Vienna. The Opec meeting on June 22 will be followed by a joint meeting with non-Opec producers on June 23. Up for discussion is a potential reduction or revision to the 1.8 million barrels/day production cut deal, which since January 2017 has supported a +60% recovery in the price of Brent crude oil, the global benchmark.
After reaching $80/barrel on Brent crude last month and after seeing Opec’s production continuing to slide – not least due to sustained declines in Venezuela – the call for action has grown louder. Ths is particularly true in the cases of Saudi Arabia and Russia, both of which have expressed concern about the potential damage of rising oil prices to global growth and demand.
The inability of most of the 14 Opec members to increase production, especially Iran (US sanctions), Iraq (lack of investment), and Venezuela (economic collapse) has raised the temperature ahead of the meeting. Geopolitical tensions are likely to resurface with US sanctions on Venezuela and soon Iran too being seen as providing Saudi Arabia an unfair advantage as it would gain market share from a production increase.
Having fought so hard to achieve higher prices it is safe to say that both Saudi Arabia and Russia will do their best not to rattle the market. On that basis, increasing production by more than what has been and will be lost from Venezuela and Iran is unlikely to occur. Given the resistance from other Opec producers it is likely that the production ceiling will be maintained but that an increase of between 500,000 and one million b/d will be agreed.
Hedge funds have been net-sellers of crude oil for the past seven weeks. This, the longest losing streak since 2013, has returned the net-long to 790,000 lots (790 million barrels), an eight-month low. On that basis the continued pressure from long-liquidation is likely to fade soon thereby limiting the downside price risk.
We maintain the view that Brent crude oil could be settling into a $71-$82/b range for the foreseeable future. Supply shocks and subsequent higher prices remains the biggest short-term risk while slowing demand growth may attract increased attention in the medium term.