If traders in the commodities markets were to check into a psych ward, the files would no doubt read “Bipolar” or “Schizophrenic.” This is so because commodity traders have a habit of fixating on a set of data one day and then quickly forgetting about the data the very next day and re-focusing on something else. Market sentiment often turns on a dime, and without notice. This shifting of sentiment in commodity futures is nothing new of course. That’s why for decades, dabbling in commodities was considered too risky for most investors, since sentiment, by definition, is unpredictable and impossible to measure.
Bipolar disorder describes a set of behaviors that causes people to have big swings between severe high and low moods, and switching from feelings of being overly happy and joyful to feelings of sadness and depression. Because of the highs and the lows -- the condition is referred to as “bipolar” disorder. In between episodes of mood swings, there are moments of so-called normalcy. Schizophrenia on the other hand is characterized by delusions, hallucinations, and incoherence, and is classified as a “thought” disorder while Bipolar disorder is a “mood” disorder. In either case, these delusions and mood swings help to explain the wild gyrations behind the erratic price movements that vex many commodity traders.
In recent years, the wild swings and volatility of the markets has become greatly magnified, due to the actions of high frequency traders (HFT), who specialize in day trading, the buying and selling huge blocks of equities, often moving in sync with whatever direction the wind might be blowing on any given day. Two-thirds of the trading volume on the New York Stock Exchange and Nasdaq is now handled by computer programs, that doesn’t require any human input. While equity markets are still the favorite den of speculation for HFT traders, many of these “black box” traders are now setting up shop in the commodities markets, such as crude oil, corn, soybeans, copper, silver, and gold.
Last year, there were several wild gyrations and mood swings to deal with, triggered by the loss of Libya’s oil output, an earthquake and tsunami in Japan, the collapse of the Greek bond market, the Bank of England’s QE-2 scheme, the ECB’s 11th hour rescue of the Euro-zone’s banking system, and signs that China’s factory sector sagging under the weight of Beijing’s monetary tightening campaign and clampdown on real estate. Shackled by fears of a severe recession in Europe and a sharp slowdown in China’s economy, trader sentiment towards commodities in general, and gold and silver in particular, turned upside down, flipping from extremely bullish, to quite negative by the close of the year.
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In 2011, both the Dow Jones Commodity Index and the gold market which were posting annualized gains of +36% in the first half of the year, came under sustained selling pressure in the second half of the year, and surprisingly tumbled to the brink of a bear market - defined as a loss of -20% from the market’s peak level. Silver was anointed as the top pick in the commodity sector at the start of 2011, and a speculative frenzy carried it to a 31-year high at $49.50 /oz. The Gold-to-Silver ratio, which shows how many ounces of silver are needed to buy an ounce of gold, fell to its lowest since 1983 below 37, against around 63 a year earlier. On the COMEX the total open interest in silver futures increased by 55-million ounces in Feb ’11 alone, shaking off its bad-boy image of a metal with high volatility and chronic oversupply. Yet in commodities, most parabolic rallies also suffer wicked corrections.
After peaking on May 1st, the silver market lost more than a third of its value in a single week. Many investors from outside the futures markets were also badly burned by the sudden collapse in silver prices. In 2010, the US Mint had sold a record 34.6 million ounces worth of American Silver Eagles. The buying frenzy continued, in the first quarter of 2011 the US Mint sold 11.7-million ounces of Silver Eagle coins. However, the parabolic surge in silver prices caught the attention of the Chicago Mercantile Exchange, which moved aggressively to increase margins for new positions by +245% in the prior weeks and months, and making it very difficult for speculators to hold long positions, when silver prices began to plunge.
For eight straight months, the Dow Jones Commodity index zig-zagged its way higher, as the Fed fulfilled its pledge to inject $600-billion of freshly printed US$’s into the coffers of the Wall Street Oligarchs. When the Fed first telegraphed its QE-2 scheme in August 2010, the high octane MZM money supply was languishing at a -2.3% annualized rate. By the time the Fed finished QE on June 30th, 2011, MZM was expanding briskly at a +9.9% clip. Traders turned increasingly to the silver market, to profit from the Fed’s debasement of the US dollar.
While the Fed wasn’t scheduled to turn-off QE-2 until the end of June 2011, some commodity traders decided to jump off the QE-2 bandwagon a few months early. They figured that the bullish trade had become too crowded, and that the timing was ripe for a nasty shakeout. On April 12th, Goldman Sachs shocked the markets by urging its clients to dump positions in crude oil, copper, cotton and platinum.
On May 3rd, Societe Generale joined Goldman Sachs in warning of tougher times for commodities prices. “The conclusion of the second round of quantitative easing, (QE-2), will deprive commodities of a key ingredient of their winning streak,” the French bank said. “This suggests that the commodities bull-run support by QE-2 may run out of steam in the third quarter if the global economy shows any signs of weakening. The end of QE-2 on June 30th could well herald the end of the commodities bull market. If emerging market economies slow and abundant liquidity dries up after QE-2, deflation fears may be back on the agenda in the second half of 2011,” SocGen warned.
SocGen’s analysis hit the bull’s eye, and was right on target. In the first half of 2011, the People’s Bank of China (PBoC) and several other central banks in Brazil, Chile, India, Russia, Peru, and the Euro-zone were hiking their interest rates and tightening liquidity, in order to arrest the inflationary pressures that were taking hold in their local economies. In particular, the growth rate of China’s M2 money supply slowed from as high as +19.7% in December 2010 to as low as +12.7% in Nov 2011. The slowdown in the M2 money supply was engineered by limiting the amount of yuan that Chinese banks could lend.
Adjusting bank reserve requirements is Beijing’s preferred tool for controlling liquidity in the Chinese money markets. However, Beijing also allowed the Chinese yuan to appreciate in value by +4% against the US-dollar last year, as a secondary tool for combating imported inflation. The PBoC rounded out its tightening campaign by lifting the cost of borrowing for banks +125-basis points higher to 6.56%, and increasing the cost of credit throughout the economy. The combined effect of these measures, along with a clampdown on the real estate market, led to a slowdown in the growth rate of China’s M2 money supply.
In turn, with less liquidity swirling around, the PBoC showed that it was willing to tolerate a bear market in the Shanghai stock market, as the price to be paid for containing the inflationary pressures emanating from the commodity markets. Out-of-control inflation is a greater threat to the stability of China’s ruling political party, rather than the direction of the stock market, since there’s little correlation between the Shanghai red-chips and economic growth, and most companies borrow money from banks to raise investment funds.
Yet the year-long slide in the Chinese stock market helped to create the illusion that perhaps, China’s economy was headed for a sharper than expected downturn – a so-called “hard landing.” These schizophrenic perceptions about a “hard landing” played into the hands of the PBoC, and China’s Politburo, since it persuaded many commodity traders to dump their speculative positions, at deeply discounted prices. When measured in terms of Chinese yuan, the Dow Jones Commodity Index tumbled -24% from its peak level, to its lowest level since August 2010, when the Fed first telegraphed QE-2 to the world. As a result, Beijing is able to quietly buy vital commodities at cheaper prices, as part of its effort to restock its depleted inventories, while shaving billions of dollars off its import bill.
One reason commodity traders are bi-polar, is because there are many moving parts in motion in the celestial sphere of the global markets that can move commodity markets in ways that are unexpected. For instance, an upward spiral in Italy’s 10-year bond yield in the second half of 2011, to a 15-year high of 7.35% by November, from around 4.60% at the start of the year, triggered a major flight of foreign capital from the Euro. Despite numerous attempts by the Euro-zone politicians and the central bank to contain the crisis, Italy’s 10-year yield remains elevated above 7%, and the Euro tumbled from as high at $1.4750 in April 2011 – at the peak of the commodities rally – to as low as $1.2650 this week.
2012 is expected to be a year of austerity for Europe. At the behest of the European Union and the International Monetary Fund, stringent programs imposing spending cuts in wages, pensions and social services, combined with the decimation of jobs, were introduced by governments across the continent. These austerity measures, designed to pay for massive bailouts of the banks following the financial crash of 2008, are now plunging Europe into new economic and social turmoil. Overall economic growth in the 17-nation Euro-zone was anemic throughout the second half of 2011, increasing by just +0.2% between July and September. Since September the general trend has been downwards. While Europe’s biggest economy, Germany, recorded significant economic growth in the second half of 2011, other major economies such as Italy and Spain registered large falls in production.
The slump in the fortunes of the euro began as the European Central Bank started to inject trillions of euros in the banking system, inflating supply in the form of new credits. The irony is, since commodities are priced in US dollars, the weaker euro versus the dollar has played a major role in weakening the Dow Jones Commodity Index in the second half of 2011. Just how long this link between the direction of the euro and commodities continues is a key question. However, at some point, commodity importers in fast-growing emerging markets, which are a key source of demand for raw materials, are expected to step-up their purchases, regardless of the euro’s value versus the US dollar.
China is the world’s largest importer of a wide array of commodities, including copper, iron ore, coking coal, soybeans, cotton, zinc, rubber, dairy, and second largest importer of crude oil and vegetable oil. Thus, China is at the epicenter of the commodity world, and along with an increasingly inter-connected global economy, China’s economy is also fueled by exporting its goods to the developed world. Europe, in particular, buys a third of Chinese exports. Amid an economic row of dominoes, commodities are in the eye of the storm.
As commodity prices reversed course in the second half of 2011, the inflationary pressures from the global commodity markets, also began to unwind rapidly. After peaking in June, the year-over-year increase for the Dow Jones Index of 19 commodities fell from an annualized rate of +36% and slid steadily for the rest of the year to end -12% lower, only its second annual decline in the last decade. Gold became a casualty of this rapid unwinding of inflation pressure, and tumbled $400 /oz, but the yellow metal still managed to cling to a +10% gain for the year, outpacing silver that ended with a loss of -8.5-percent.
Yet Bipolar markets won’t continue to travel in a straight line forever. Inevitably, there will be short-term reversals along the way, or even major trend changers. After tumbling to the threshold of a bear market, following a -20% slide from its all-time high at $1925 /oz, buyers emerged in the first week of 2012, to bid-up gold prices as much as $100 /oz from its recent low at $1,525 /oz. Long-term “Buy-and-Hold” investors continue to favor gold as a haven amid uncertainty, because of deep seated skepticism about the value of all paper currencies as central banks dramatically increase the world’s money supply in order to bailout banks in Europe and the US, and now in Beijing, where the PBoC is under instructions to begin re-opening the money spigots, in order to boost the Chinese economy.
It’s an election year for the presidency in the United States, and a majority of Treasury bond dealers predict the Fed will unleash QE-3 in the months ahead. If correct, QE-3 would provide a major shot of adrenalin for commodity markets and precious metals. Already, the European Central Bank has embarked on “backdoor QE,” and is flooding the European banking system with a tsunami of euros. Although a weaker euro led to a weakening of commodity prices in 2011, this faulty linkage is expected begin to break down soon. Gold could be the first hard asset to increase in value relative to the euro, as the ECB increases the money supply.
Looking at the big picture, the “Commodity Super Cycle” that began 10-years ago still remains intact for the longer-term, a cycle that could lift commodity prices sharply higher for at least another decade. Each day, the world’s population increases by 225,000 human beings. At the same time, the size of the world’s middle class is increasing by roughly 70-million people a year, with more money to spend on commodities. By 2030, the world’s GDP is expected to double in size to $130-trillion. Such massive demands on the earth’s finite resources will eventually outpace supply and lead to severe shortages of many commodities worldwide. Tighter supplies would be rationed through much higher prices. Yet as 2011 showed, the long-term bullish view of the “Commodity Super Cycle” is occasionally interrupted in the notoriously volatile futures markets by short-term fluctuations.
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