Commodities Are Waving a Red Flag

 |  Includes: GLD, SLV, SPY
by: Pradeep Kandasamy
Commodity markets have been waving some red flags recently, the most significant of all is the decoupling from the dollar. Below are some factors why commodities could be under pressure for some time.
Commodities and dollar decouple
CRB/Reuters US Spot All Commodities Index (CRB Index) is down more than 5% from the peak it hit during April 2011.
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This is quite significant, as the USD over this period has been weak. The USD Index is actually down 1.14% from 8 April 2011 when the CRB Index hit its peak. While the CRB index is down 5% against the USD, it is down over 6% against the basket of currencies the USD Index is calculated on.
In the recent risk bounce in the last week of June, while equities rallied, treasuries sold off and USD went lower; commodities did not participate.
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The selloff in commodities has been almost across the board. Exceptions are Sugar, Cocoa, Cattle and Natural Gas.
Capital flows out of commodity based exchange traded products [ETP]
Almost all commodity ETPs have seen outflows in May. The total outflow from commodity linked exchange traded products in May is estimated at just under USD 4 Billion. This is the worst outflow in the last four years. Something which is really interesting is the time frame of outflows. In the past when there is an outflow of capital from commodity ETPs, it tends to quickly return back; but the recent data shows otherwise.
This is very applicable to Gold, where the current outflow of capital has been the longest in recent history. The below chart shows the outstanding number of shares of SPDR Gold Trust (NYSEARCA:GLD). The curves in the chart depict the time frames of outflows. Capital outflow in gold, which started in late December 2010, has not yet returned, making it the longest outflow of capital from Gold. This situation is the same in Silver. Has something changed?
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Silver exposed the fallibility of commodities
The notion of commodities being a safe trade has been questioned after what happened in Silver markets. Silver was considered to be a safe haven, as it’s a precious metal in addition to having industrial utility. After a parabolic move upwards, mainly driven by speculation, Silver crashed more than 30% in a matter of days and has not yet recovered.
At the peak, the largest Silver ETF (NYSEARCA:SLV), traded more shares on a daily basis than SPDR S&P 500 ETF Trust (NYSEARCA:SPY), the largest ETF in the world. This shows the extent of speculation in silver markets. The notion that commodities are a one-way trade has been seriously questioned.
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Interest rates & liquidity situation have moved against commodities
While real interest rate may be still negative, nominal interest rates have gone up in many emerging markets, like India and China. In addition to higher interest rates, reserve ratios for the banking system have also been raised in many emerging markets, reducing available liquidity. Overall, the cost of owning commodities as an investment has gone up in emerging markets.
The chart below shows the historic 1m SHIBOR rates (onshore Chinese interbank RMB interest rate). Note that in 2011, the interest rates are much higher than what was seen in 2010.
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it is the same case in India; the chart below shows 1m MIBOR rates (onshore Indian interbank INR interest rate).
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End of QE2 and No immediate QE3
Though the Fed denies its policies have anything to do with higher commodity prices, there is evidence which shows otherwise.
The below chart shows the number of outstanding shares of SPDR Gold Trust ETF. Note the sharp flow of capital into the ETF when QE1 started in 2008, and again in 2010 in anticipation of QE2. This is true not just for gold, but for other commodities as well.
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Now that QE2 is over and there are no signs of QE3, there should be some reversal of flows from commodities in general. This should put some pressure on prices.
US growth seems to be slowing
US growth for Q1 came much slower than expected at 1.9% YOY. Most banks and the Fed have cut their growth forecast for rest of the year. Emerging markets growth rates have stabilized as they tackle their inflation troubles. This should also add some downside pressure to commodity prices if the soft economic data continues.
There are some signs in commodity markets which are unusual, like the decoupling with USD and capital outflows not returning. Macro and liquidity situations have also moved against commodities, like higher interest rates in emerging markets, slower growth in US and the end of QE2. With the huge inflows over the last 3 years at risk of reversing, Commodities could be under pressure for some time.

Disclosure: I am short GLD.