Head of Commodity Strategy
Summary: It’s been a stormy week for global financial markets and commodities were no exception as they struggled under the pressure exerted by sinking equities, rising US interest rates and a strong dollar.
Commodities remained exposed to broad-based selling this past week. For a third consecutive week, the sector struggled to put up a defence against the challenging combination of rising US interest rates, a strong dollar and the global equity rout, which has now spread to the US market.
The Bloomberg Commodity index, which tracks a basket of key commodities in energy, metals and agriculture, was down 2% on the week, with losses in energy, industrial metals and grains offsetting renewed safe-haven demand for precious metals, led by gold.
The global rout in stocks has spread to the US with the major indices having seen their gains for the year wiped out. The Nasdaq index, which contains several of the technology bellwethers, is currently on track to record its worst monthly performance since the Global Financial Crisis in 2008.
Financial markets are waking up to the fact that the strength of the so-called central bank “put” is weakening, as QT (quantitative tightening) in the US slowly begins to drain the excess dollar liquidity that global markets have thrived on for the past decade. During this time volatility stayed compressed in the belief that any weakness in bonds and stocks would be bought as the above mentioned excess liquidity needed to find a home.
The risk of a major reversal already became clear in early October when Brent crude oil broke above $80/barrel and surged to almost $87/b. During this rally, hedge funds turned sellers, especially of WTI crude oil, instead of buying into the strength as they normally do. It highlights once again how crude oil is often traded with a macroeconomic view instead of one purely focusing on crude oil supply and demand fundamentals.
As the price of oil rose so too did the risk to the outlook for demand, with many emerging market economies already being troubled by a heavy load of dollar debt at a time of rising funding costs and a stronger dollar.
Three weeks later and following an 11% slump Brent crude has fallen back to support at $75/b. The pledge from Saudi Arabia to pump as hard as possible is going a long way to calm any worries about supply shortages over the coming months. Opec has even raised some concerns that the market could end up being oversupplied as we are entering the seasonal slowdown in global demand.
Brent crude oil has made a swift return to $75/b, a level around which it pivoted for several months before the break higher last month. A break below could see it target $70/b while $80/b has once again been established as resistance.
As per our recently released Q4 Outlook we believe the "lower growth leading to lower demand" narrative eventually will take its toll on crude oil prices. However, we also believe that the market may have jumped the gun too soon with the supply disruption impact from Iran not yet fully known. Opec’s and especially Saudi Arabia’s pledge to “produce as much as they can” could backfire should the need for additional barrels rise by more than expected.
In such a circumstance the market will begin to worry that lower spare capacity would leave the market exposed in the event of production outages from other producers such as Iraq, Venezuela, Libya and Nigeria.
Overall it is our belief that the above uncertainty is likely to provide some short-term support once the panic selling is over. With $75/b now acting as support, we see Brent crude oil making its way back up towards $80/b in preparation for US sanctions taking their full toll on supply.
Gold benefits from flight to safety
The month-long sell-off in gold increasingly looks like it’s over with the yellow metal focus having switched from the headwind of a stronger dollar to the tailwind being created by renewed safe-haven demand in response to the global market rout in stocks. This change has further been supported by demand for Japanese yen and US government bonds where the yield on 10-year notes has fallen back below 3.1%. The break above this level caused widespread panic back on October 3 and it helped trigger the rout in US stocks.
Given gold’s relative strong performance so far this week (+0.8%) despite the stronger dollar (+1%) it is likely that resistance at $1,240/oz could be challenged and broken very soon. Not least considering continued stock market weakness on Friday following disappointing results from technology behemoths Amazon and Alphabet.
Gold’s weak performance was until recently strongly linked to the direction of the yuan, which has fallen by 7% so far this year. That correlation is now fading with the rout in equity markets and lower bond yields attracting a safe-haven bid that so far has proven to be stronger than the headwind caused by the dollar reaching the highest level since June 2017.
“The recent USD strength is pushing very hard on the USDCNY exchange rate and the CNY, or renminbi floor that has been established by China ahead of the 7.00 level is suppressing volatility in currencies as the world watches and waits whether the world’s most important exchange rate will remain contained.
The pressure on this level to give way is enormous as the Chinese currency remains overvalued on a real effective basis and as the country has moved to ease monetary policy to support its deleveraging efforts in recent months. This at a time when the Fed has continued to tighten policy via rate hikes and quantitative tightening (reducing its balance sheet), tightening USD liquidity the world over.”
As China is the world’s biggest importer of raw materials, a shift in its currency could have major ramifications considering the current trade war. A weaker yuan is likely to attract a response from the US and with that the risk to global growth will only strengthen.
Other commodities in brief:
HG copper has seen relatively calm market conditions this past month with the negative impact of a stronger dollar being offset by supportive physical fundamentals. In the short term the market rout in global stocks and the risk of a weaker yuan are likely to keep the metal on the defensive. This despite talk of a future supply deficit and signs that buyers are struggling to find spot material after available inventories monitored by the London Metal Exchange sank to their lowest level since 2005.
Hedge funds had up until early October been accumulating a record and, in the end, unsustainable short position. Funds will continue to sell into weakness – or buy into strength – until the technical and/or fundamental picture changes. In this case, it was primarily a change in the technical outlook that created the mad rush towards the exit.
Having found resistance at $1.25/lb, the market is now consolidating with focus on BRL and the second round of the Brazilian presidential election on October 28. For the bullish sentiment to be maintained, coffee needs to find support ahead of $1.14/lb.
It reached a nine-month low in response to USD strength and increased supply estimates from the Black Sea region, both of which have created a challenging environment for US exporters trying to compete with supplies from other regions, not least Europe and Russia.