The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:

FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”

At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

Can the rally in global commodities be sustained?

We are seeing broad improvements across global commodity markets. To be sure, commodity valuations are still at depressed levels relative to the past decade, but after a prolonged decline, broad indices seem to have stabilized.

CRB BLS broad commodity index (source: barchart)

The rally across a number of commodity sectors however resulted from a variety of factors, most of which are believed to be transient. For example the cold winter pushed up US natural gas prices (though exports could provide a floor - see post) and hot/dry conditions in Brazil sent coffee prices flying (see chart). Some argue that the two unusual weather patterns are related - a scary thought.

The Ukrainian crisis on the other hand pushed up wheat and corn prices.

WSJ: - Wheat prices rose as much as 6.8% before easing in midday trading. Wheat for March delivery at the Chicago Board of Trade settled at $6.26 a bushel, up 27 cents, the highest closing price in nearly three months.

May US corn futures (source: barchart)

Corn futures also gained from the Ukraine unrest, finishing at their highest price in more than five months. Corn for March delivery rose 6 cents, or 1.4%, to $4.64 a bushel in Chicago.

Ukraine grain exports continued Monday despite the unrest. However, looking ahead, grain buyers that would normally consider the country for grain shipments are largely turning elsewhere, three Europe-based traders who deal in physical grain supplies said Monday. The traders said difficulty obtaining financing due to the country's turmoil is slowing business for Ukraine-based grain companies.

Gold has also been recovering recently - up 12% for the year on slow Fed taper and better demand.

It's not clear if these higher prices across a number of commodities can be sustained. Slower growth in China (combined with weaker yuan) is not helping base metals such as copper for example. Many analysts are also quite bearish on crude oil. Should the geopolitical risks subside, we may get a correction there. Nevertheless we haven't had a commodities rally like this in quite some time.

SoberLook.com

From our sponsor:

Commodities under pressure again

The rally in commodities, which started in August has petered out. Several major commodities indices show significant declines on a year-over-year basis.

CRB BLS Spot Cash (commodity) Index (source: Barchart)

Dow Jones UBS Commodity Index

There are several reasons prices have turned lower again:

1. The government shutdown certainly is not helping - if anything, just due to slower expected economic activity.
2. With the Syria strike seemingly off the table for now and new hopes for a better relationship with Iran, energy prices have stabilized.
3. A number of emerging market nations are still reeling from recent capital outflows, weak currencies, and tighter monetary conditions. This is expected to cap demand for raw materials and energy.
4. While the Fed chose to keep up the securities purchases, taper is only a matter of time. And that is also a negative for commodities.
5. There seems to be a commodity fund that was forced to liquidate positions - which is adding to the pressure across various commodity sectors.

Reuters: - Prices for gold, copper, crude oil and a number of other commodities fell on Tuesday after the U.S. government's partial shutdown caused investors to sell and discouraged others from buying.

In addition, talk circulated that a commodities fund was having to liquidate positions.

SoberLook.com

From our sponsor:

The FOMC is running out of excuses to maintain current policy

The retail sales measure from the Commerce Department survey came in below expectations today with 0.2% month-over-month change vs. 0.3% expected. Given that the numbers missed the forecast, why then did treasuries sell off sharply after the release?

10y treasury yield (source: WSJ)

The answer is that while retail sales growth has not been spectacular, it is sufficiently strong for the Fed to begin reducing its securities purchases shortly. Sales ex-autos were up 0.4% (auto sales are volatile and other recent indicators of auto sales have been strong.) The year-over-year ex-auto retail sales number is historically on the lower end, but falls within the 2.5%-5% range that some view as stable.

Given that the consumer is such a large part of the GDP, some economists are already revising their GDP forecasts up. The FOMC now has only one key potential showstopper: the ultra-low inflation rate scenario.  As James Bullard pointed out in his June speech, inflation measures were collapsing earlier this year (see post), raising the specter of deflationary risks. If that trend were to continue, the Fed would go into a holding pattern.

But inflation indicators in the US seem to have stabilized. Commodity prices have bottomed out (for now), as copper bounced (see post) and energy prices remain elevated.

CRB BLS Spot Index of 23 commodity markets (source: CRB/barchart)

Moreover, market-implied inflation expectations have risen since the dip earlier this summer.

10 Year TIPS/Treasury Breakeven Rate
(implied inflation expectation; source: Ychart)

With deflation no longer a high probability near-term threat, the FOMC has run out of excuses. Unless the labor market suddenly takes a material turn for the worse this month, we should see the beginning of the end for QE3 shortly.

SoberLook.com

From our sponsor:

Commodity prices under pressure

As oil prices retreated from the refinery demand driven spike (see post), the CRB BLS Spot Index of 23 commodity markets (see description) hit a new low for the year. Per earlier discussion (see post), the equity markets have been discounting the rally in crude and so far have been proven right.

Source: Barchart

Recent price declines in commodities are not limited to energy however. Corn, coffee, copper, and several other products are under pressure.

CORN FUTURES

Deceleration in emerging markets' economic growth (particularly China) and increasing competition among commodity producing nations have been responsible for some of the declines. Tighter current or expected monetary policy, whether in India, China, Turkey, or in the US (accompanied by higher interest rates) has also added to weakness in a number of commodity sectors.

SoberLook.com

From our sponsor:

The impact of commodity index rebalancing

Every year the two major commodity indices (S&P GSCI the DJUBS) are rebalanced based on the sizes of specific commodity markets. This year's changes are smaller than last year's adjustments, which materially impacted the Brent/WTI mix (see discussion). Nevertheless the rebalancing is expected to generate flows in or out of certain commodities by institutional investors and funds that track these indices.

The chart below from Credit Suisse shows what the impact of the next rebalancing is expected to be. Once again, the largest move will be a reduction in WTI and an increase in Brent weights. But flows in other commodities are expected as well.

Source: Credit Suisse

The overall impact will be a net inflow into energy commodities, and a net outflow from agricultural commodities and an outflow from base metals.

SoberLook.com

Monetary expansion, the US dollar, and commodity prices

Economists continue to insist that there is no connection between the Fed's monetary expansion programs and increases in commodity prices, particularly agricultural products globally (discussed here). Here is a typical comment:

If it is commonly believed that the FOMC can cause a worldwide food shortage then we are truly in a dark age of macro. The FOMC has no ability to raise the price of commodities relative to national income, and I can't even imagine the rationale that monetary expansion could somehow increased prices internationally (that is, denominated in foreign currencies). The only way they could raise food prices in real terms is if they could spur increased food consumption domestically, which would be much more likely if they strengthened the dollar than if they weakened it. The FOMC can cause a lot of trouble, but this is just not on the list of problems they can cause, and certainly not via monetary expansion.

Unfortunately macroeconomic theory here diverges from market experience. Monetary expansion in the recent past corresponded with significant dollar weakness. The chart below shows the dollar weakening during both QE1 and QE2. "Twist" on the other hand did not involve monetary expansion and only focused on reducing the average duration of treasuries.

Source: BNP Paribas

Dollar weakness to any commodity trader is a signal to buy - which is not necessarily linked to demand fundamentals. Those who don't believe this should only take a look at the following chart comparing the dollar (DXY) with the CRB commodity index.

Source: Bloomberg

What's important to point out here is that the commodity price movements have been much larger than the dollar movements. In fact on a percentage basis the CRB range in the graph above is almost double the dollar range. That means even for currencies that are not in any way tied to the dollar (although a number of emerging market currencies are), when the dollar weakens, commodity prices move higher even if denominated in these other currencies. Commodity price increases due to dollar weakness therefore propagate globally even in nations whose currencies are not linked to the dollar. This empirical relationship drives global commodity markets even if supply/demand fundamentals don't warrant such adjustments. But when one faces tight and uncertain supply conditions to begin with (as we have now for agricultural commodities), dollar weakness will force an even larger commodities swings to the upside.

In 2011 the CIA was chastised for not being able to see the Arab Spring coming. Where did all that pro-democracy fervor come from all of a sudden? Why wasn't the CIA able to see key signs of the movement earlier? The answer has less to do with zeal for democracy and more to do with not being able to buy food. As food prices spiked across the Arab world, so did the protests.

Source: Bloomberg

Certainly in the long run macroeconomic fundamentals should play out. But we don't live in "the long run". Global markets take seconds to reprice, usually far overshooting/distorting the "fundamentals". And, as the Arab Spring showed, people don't wait for these fundamentals to settle to their expected levels.

SoberLook.com

The longer term trend in commodities will be driven by China, not central banks

Commodities seem to have found a support level after a massive selloff recently. The CRB index recently broke through the previous support, correcting back to the levels of the early days of QE2. Have we now stabilized?

CRB Commodity Index

This stabilization in the past few days seems to be driven by stories of a potential coordinated central bank action that will supposedly provide liquidity after the Greek election this weekend. Given the global slowdown, central banks seem to be the only source of support for risk assets, as global addiction to stimulus continues.

Reuters: - European Central Bank President Mario Draghi said on Friday the bank was ready to support euro zone banks, should it be required, while Bank of Japan Governor Masaaki Shirakawa said central banks can offer liquidity to calm markets in case the weekend Greek elections heighten tension.

But we've seen this movie before. A new action from central banks, even a coordinated one, is not expected to last long. As soon as stimulus stops, risk assets (such as commodities) begin to correct (unless another stimulus action is anticipated). Ultimately any lasting strength in the commodities markets will have to come from emerging markets growth - particularly from China. The chart below from the ISI Group shows how strong the relationship between China's corporate sales and global commodity valuations has been.

Source: ISI Group

If China experiences a "hard landing", it would be hard to imagine that the ECB, the Fed, and the BoJ can really do anything to prop up risk assets. And although analysts are not yet predicting such a sharp slowdown, even the expectations from within China have not been great:

Reuters: - China's annual economic growth could drop below 7 percent in the second quarter, an influential government adviser said in published remarks on Wednesday, the most pessimistic forecast of any government or private-sector economist.

Sub-7 percent growth would reflect the pace of the economy during the global financial crisis. China reported economic growth of just 6.6 percent in the first quarter of 2009.

Ultimately to understand the longer term trend in the commodity markets, one needs to pay far more attention to China than to central banks.

SoberLook.com

ISDA and CFTC are fighting it out over commodity limit rules

Many readers were upset with the Sober Look post from two years ago named Energy speculation vs. hedging - regulate it all, ask questions later. Supposedly oil prices in the summer of 2008 had nothing to do with China’s and India’s rapid growth. It was all speculators. Right.

In fact a 2009 study showed that there is no evidence that futures trading impacts physical commodity pricing. We quote that study again here:

...the results indicate that in recent years the relationship between futures and physical commodity markets for industrial metals was not disturbed by financial investors. Instead, commodity spot prices changes are driven by world economy activity and financial investors are merely responding to these price changes. This conclusion is strongly confirmed by the economic developments in 2008.

But publicity driven politicians and zealous regulators (CFTC) continued on their war path to limit futures position holdings and impose other restrictions. Even without those limits in place, the threat of such action cause distortions in the market place such as ETFs trading at substantial premium to NAV (see Another ETF giving Larry a headache)
Today with the CFTC rules finalized, ISDA and SIFMA (Securities Industry and Financial Markets Association) finally filed a legal challenge to the CFTC’s new rules.

MarketWatch: The Associations believe that the Position Limits Rule may adversely impact commodities markets and market participants, including end-users, by reducing liquidity and increasing price volatility.
…
"The evidence is overwhelming that position limits are, at best, unnecessary and may, at worst, negatively impact commodity markets and users," Mr. Voldstad said. "Numerous studies have been conducted by government agencies and others into commodity price volatility and little, if any, support exists for the idea that speculation causes that volatility or that position limits curb speculation."
…
The Associations have filed suit in federal court in the District of Columbia, alleging that the CFTC:

• Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary; 
• Failed to present a reasoned analysis or consider all evidence in setting position limits;
• Failed to conduct an adequate cost-benefit analysis as required by law;
• Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

Markets regulation is vital in order to build investor confidence that in turn provides financing to corporations, municipalities, individuals etc. But we need smart regulation, not just what makes for good publicity or sells newspapers.

Another ETF giving Larry a headache

Having given up on trying to invest in natural gas with USG, Larry (the retail investor) decided to go for a broad commodities index. And why not. The dollar is on a downward path and some commodities exposure could do the old portfolio some good. Larry chose GSG, the liquid iShares ETF that mimics the the Goldman commodities index (S&P GSCI).

But something caught Larry's attention as he was doing his research. From Barclays Global Investors (BGI):

[BGI] has temporarily suspended further creation of new shares of iShares S&P GSCI Commodity-Indexed Trust (the "Trust"). The Trust is listed and trades on the NYSE Arca under the ticker GSG. As disclosed in the Trust's prospectus, a suspension may cause the market price of the Trust's shares to vary more from the Trust's net asset value than historically.

What? Another closed ETF with no more share creation? And what a surprise, it's starting to trade at a premium (the announcement to suspend share creation was on August 24th). GSG is easier to short than USG, so the premium may periodically get taken out, but if the market sees that the share creation will be suspended for a while, the premium may persist.



Larry is now concerned because in addition to taking on the commodity exposure, he's also taking on some CFTC regulatory risk. Plus he may be taking on the risk of GSG/iShares getting dealers to line up a TRS program instead of futures contracts that GSG normally used.

From BGI:

"We are actively working with regulators, product partners and exchanges to explore solutions that will lead to resumption of the creation of new shares of the iShares S&P GSCI Commodity-Indexed Trust to satisfy demand," said Michael Latham, Co-CEO of iShares at Barclays Global Investors. "We've taken this temporary step to protect existing investors from being adversely affected by market reaction to proposed new regulations of commodity futures that have created uncertainty.

So thanks again CFTC. Not only have you stopped Larry and his vicious gang from speculating on natural gas, but you may also be able to keep him from the broad commodity index speculation. Good to know that our commodity markets are protected and supervisory objectives well prioritized.

Commodities priced in dollars still produce gains in local currencies

We have received a number of comments regarding the recent post called "No shortage of those who want to see the dollar lower" that points to the fact that numerous parties, particularly the commodity producers, would love to see the dollar lower. Many readers however argue that because commodities are priced in dollars, the dollar declines would offset the commodities rally when converted to native currencies. Therefore they argue that producers should be indifferent to dollar declines and in fact would want a stronger dollar to stimulate demand.

In practice however this argument just doesn't hold up. Consider the first half of 2008 that saw a broad commodities rally triggered by a weak dollar. Here are the facts:

* Dollar move against a basket of 6 currencies: ---- down 4.5%
* Copper priced in Australian dollar: ---- up 12%
* Aluminum priced in Australian dollar: ---- up 18%
* Oil priced in Russian Ruble: ---- up 50%

This year we have a similar story developing. The sustained dollar slide started in May, and here are the results since then (May-1 to Sep-9):

* Dollar move against a basket of 6 currencies: ---- down 9%
* Copper priced in Australian dollar: ---- up 19%
* Aluminum priced in Australian dollar: ---- up 4%
* Oil priced in Russian Ruble: ---- up 16%

Similar results can be obtained using other producer currencies and commodities. The conclusion here is that when we experience a sustained commodity rally, the rally more than offsets any dollar declines, generally producing significant gains in local currencies. That's why most commodity producers (including those in the US) are interested in a weaker dollar (although many will not publicly admit that).

Derivatives trading causing price spikes? Study shows it's just hype.

Following up on our earlier post called Energy speculation vs. hedging - regulate it all, ask questions later, here is a recent study from the Fed that contradicts what some politicians are claiming - that somehow futures trading activity (or what they call "speculation") has a lasting impact on spot prices.

The author, George Korniotis analyzes industrial metals with and without the corresponding futures markets. The chart below from the paper shows the price growth rates for the two types of markets: "traded" and "non-traded".



Here is the summary:

...the results indicate that in recent years the relationship between futures and physical commodity markets for industrial metals was not disturbed by financial investors. Instead, commodity spot prices changes are driven by world economy activity and financial investors are merely responding to these price changes. This conclusion is strongly confirmed by the economic developments in 2008.

Rather than tackling the real issue, which is the US dependence on crude oil, politicians continue to blame derivatives markets for price spikes in energy. They also claim that the same problem exists in other commodities. Maybe they should take a sober look at the evidence to the contrary.