Why Commodities Crashed

 |  About: iShares Silver Trust ETF (SLV)
by: Felix Salmon

If you want to see market reporting done right, I can recommend the 2,000-word Reuters special report on Thursday’s commodities crash. It doesn’t just pick a random news event or gesture vaguely at “worries about economic growth” while saying what prices did; it looks at the mechanisms behind the market moves and what might have caused them.

It’s worth underlining that Thursday’s percentage declines in commodities like silver and oil would count as a full-on disaster if they occurred in the stock market. Commodities markets are rowdier places than stock markets, however, and the only people who really got hurt are sophisticated investors who can take their medicine.

The move was certainly accelerated by the rise of algorithms and high-frequency traders, who have moved quite aggressively from stocks into commodities of late. These black boxes can go from being very long to very short in an alarmingly short space of time, and I suspect that many of them made, rather than lost, money in the volatility.

But there was also a sense that this move had to happen. Between early February and early May, the yield on the 10-year Treasury bond fell from 3.7% to less than 3.2%. That’s a massive move in Treasury yields, which indicates that market fears about inflation are abating significantly. At the same time, however, the price of silver — a classic inflation hedge — rose from $27 to $47. One of those two markets was wrong — and it was much more likely to be the thin silver market than the Treasuries. Silver was bound to fall in price; the only question was when.

When the inevitable silver crash happened, it took down other commodities like oil with it. That’s because of all the speculation in the market, and the fact that funds which speculate in silver tend to be exactly the same funds speculating in oil. When you get a big margin call in silver (and margin requirements on silver had just been raised before the crash), then you have to sell some of your other holdings to meet that call. And your most liquid holding is likely to be in oil.

At times of volatility, correlations move towards 1. We saw that in every market during the crisis, and we saw it again in commodities on Thursday. Which is why protecting yourself with diversification is so dangerous. Just when you need the protection, it disappears.

Disclosure: No positions