The Commodity Bubble Is Bursting

by: Brian Dolan

The Week Ahead:

  • The US Dollar recovers as risk reverses
  • The commodity bubble is bursting
  • EZ uncertainty rises amid speculation, sovereign concerns
  • Chinese rate hike fears slam risk markets

The US Dollar recovers as risk reverses

Despite fears of its imminent demise post-QE2, the USD staged a healthy rebound this past week, aided in part by EUR weakness. To be sure, the bulk of USD strength was seen against the European single currency, as peripheral sovereign debt concerns flared up again (more below), but the buck gained ground against the JPY, too, on the back of higher US Treasury rates. QE2 wasn't supposed to work like this; the USD was supposed to go down and Treasury yields were supposed to fall. But the exact opposite has happened, suggesting that extreme one-sided positioning played a role. While position adjustments are typically of a short duration (e.g. a couple weeks), we think this may end up being a more significant shift in market direction, likely lasting into year-end at the minimum. As we indicated last week, we see relative growth prospects as the horse pulling the cart (monetary policy) and leading currencies and here lies the basis for our view of further USD recovery potential.

Behind the scenes of turmoil in European bond markets this past week, 3Q Eurozone GDP posted a meager 0.4% QoQ increase while Sept. industrial production fell -0.9 MoM (exp. +0.2%), suggesting Eurozone growth was already slowing in the 3Q. With the ECB intent on its exit strategy and governments adopting austerity policies, we think Eurozone growth is only likely to weaken further. Weaker outlooks will only intensify debt and deficit concerns, keeping sovereign debt concerns front and center.

In contrast, US data has turned slightly more upbeat, reflected in higher US yields. Some would argue that bond markets are pricing in higher inflation, but we don't see inflation becoming an issue until output gaps are closed on better growth. Viewed from that angle, bond markets may instead be pricing-in improved prospects for US growth, perhaps drawing confidence from the Fed willingness to pursue unconventional policies. At the minimum, US rates have stopped being a USD-negative and may begin to be USD supportive if yields continue higher. We're looking at 2.78/2.84% in 10-year US Treasury yields as critical resistance, above which rates (and USD/JPY) are likely to move higher. Next week, we look for the EUR to remain soft across the board, the USD to stay supported overall, AUD and NZD to weaken alongside expected commodity weakness, and CAD and GBP to stay a bit more resilient (as long as the BOE minutes don't completely contradict the more-hawkish Quarterly Inflation Report).

The commodity bubble is bursting

After defying gravity for a few days as the USD recovered, commodity markets have fallen back to earth with a thud. Margin requirement increases, fears of Chinese rate hikes (more below), over-extended positioning, and the USD recovery were all contributing factors to the reversal. We would also note that commodities (rising) have been diverging from the Baltic Dry Index (falling), viewed as a proxy for global commodity demand, for the last two months at least. In commodities, too, we think there is further downside potential as global growth prospects are marked lower on weaker European, Japanese and potentially Chinese demand. We would also note that the G20 agreement to disagree will allow emerging nations to continue to pursue capital and possibly currency restrictions, likely slowing growth and undercutting demand in those countries. If the US dollar recovers further as expected, that should also weigh on commodity prices ahead. In gold, prices are closing just below the daily Kijun line at 1370, suggesting potential down to the cloud around 1310/15. Silver is closing above its 25.85 Kijun line, but the massive shooting star on the weekly candles suggests further weakness ahead. WTI crude oil is finishing out on a critical pivot at $84/85/bbl, and weakness below next week would suggest declines to $80/bbl and lower ahead.

EZ uncertainty rises amid speculation, sovereign concerns

EUR/USD declined roughly -2.5% this week as sovereign debt concerns mounted. The blowout in peripheral yields contributed to a declining EUR as Irish and Portuguese 10-year yields reached record high levels at 8.896% and 7.036% respectively. The yields have been climbing steadily since EU leaders agreed to consider German Chancellor Angela Merkel’s proposal for a permanent rescue mechanism that involves restructuring with losses for private holders of sovereign debt as opposed to losses being transferred to the tax payer. The crisis-resolution mechanism discussions continued at the G-20 summit in Seoul and resulted in a significant reduction in demand and therefore higher risk premiums to hold sovereign debt which ultimately weighed on the common currency.

Though these debt worries are widespread in the Euro zone, the market is currently fixated on the Irish situation. Rumors are currently circulating that EU talks are underway that will lead to a financial rescue plan for Ireland as early as next week. Ireland’s Finance Ministry stated it had made no application for emergency funding from the EU and the European Commission said it has not received an aid request from Ireland. This is reminiscent of similar denials from Greece prior to its acceptance of an EU bailout. Speculation of a potential bailout has led to a sharp reversal in peripheral yields which is supportive of EUR/USD. There is significant risk to the downside, even if Ireland receives aid the focus will then shift to Portugal and possibly Spain (which will be of great concern given that Spain represents about 11.5% of EZ GDP compared to Ireland’s 1.7% share of EZ GDP).

EUR/USD remains under pressure while below its daily Tenkan and Kijun line which currently converge around 1.3925/30. Key levels to the downside are the top of the weekly Ichimoku cloud and 100-week simple moving average which converge around 1.3640/45. Below there sees the top of the daily Ichimoku cloud at about 1.3520 and a drop through here may see the bottom of the cloud (and August highs) of around 1.3310/30. An upside break above 1.3925/30 may see to the psychological 1.4000 level ahead of recent highs around 1.4280.

Chinese rate hike fears slam risk markets

Over the past month, the PBOC has taken a series of steps in efforts to curb inflation and manage liquidity. On October 19th, China’s central bank raised the benchmark interest rate by 25 bps to 5.56%, the first hike since 2007. The historic rate hike was followed up with the implementation of SAFE’s controls to slow speculative capital inflows along with two additional reserve requirement ratio (RRR) hikes of 25 bps and 50 bps, in October and November respectively. However, Thursday’s data releases highlighted the inefficacy of these steps as headline CPI rose by a higher than expected +4.4% on the year compared to a prior +3.6% rise. This significantly increases the likelihood that the nation will miss its target inflation rate of 3%. Further concerns arose from the release of the Net New Yuan Loans which remained elevated at 588bln Yuan against expectations of 450B Yuan despite the government’s attempts to alter lending behavior.

The stronger than expected loan growth and heightened inflation risks suggest further steps will be necessary to effectively manage liquidity and control inflation risks. We expect the PBOC to continue the implementation of open market operations for liquidity management and tighten monetary policy when deemed necessary. We believe another 25bp hike in the benchmark interest rate is likely and expect further tightening to be implemented towards year-end or early 2011 with anticipation leading to the additional hike to keep pressure on commodities, commodity currencies, and equities in the weeks ahead.

Disclosure: No Postions

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