Commodities in Freefall and What it Means



Commodities declined sharply last week, as the broad-based commodity ETF DBC declined more than 1%, with most of the weakness coming on Friday.  The ETF and most commodity indices moved to multi-month lows, implying more weakness ahead.

The decline in commodities came despite a weaker dollar and generally “OK” global economic data. Continued rotation out of the commodity space by investors was the main catalyst for the declines.

Gold imploded last week, falling 5% on Friday alone and 6% for the week.  The reasons for the weakness in gold are the same as they have been:  negative momentum and money rotation out of gold due to a reduction of risk globally and a total lack of inflation (and potential threat of deflation in Europe).

The one main catalyst for Friday’s decline, however, was the report that Cyprus will have to sell some of its gold (or pledge it as collateral against EU loans), which sets a significant precedent and obviously got gold longs very nervous.

Despite a very low speculative net long position and a rising monetary base, money flows are trumping fundamentals and clearly there is very heavy negative momentum in gold.  I was very, very surprised by the waterfall decline Friday, and clearly the technical damage done was significant.

What to do with gold now depends on your time horizon.  I, for one, continue to see all signs pointing to inflation over the longer term, thanks to continued central bank accommodation and excess liquidity.  I’m very confident inflation will be a problem in the future, and as such I would/am not selling longer-term gold holdings.  With gold and silver plunging again this morning we are in the midst of a sellers panic at this point, although I’m hearing there is decent support in the mid $1300’s.  Silver and copper also declined sharply last Friday and this morning in sympathy with gold, and both finished lower on the week (with silver hitting new 52-week lows).

Energy declined last week as WTI Crude broke through support at the $91/bbl. level and Brent crude fell basically to previous lows for the year.  Both commodities were pressured by general commodity market weakness.

Finally, grain markets were the outperformers last week as the entire complex rallied, bouncing from an oversold condition after a USDA World Agricultural Supply/Demand Estimate report showed that the supply of corn and soybeans hadn’t grown as much as thought (the report wasn’t bullish, it just wasn’t as bearish as feared).  Given the number of shorts in the grains, that led to a short covering rally, although the supply/demand picture remains uncertain and given the planting intentions for this year, it’s not certain that you’re buying “value” in the grains at these levels.

The weakness in the commodity markets remains an important topic to monitor.  On one hand, you can make the case the decline is justified, given recent supply increases in commodities like copper, WTI Crude and steel.  But, while those supply increases are totally legitimate, they are overshadowing the weakness in the global economy, which is something I think needs to be considered.

Commodities as an asset class are signaling one of two things:  1) That we are returning to a period like the 1980s where increased supply, reduced macroeconomic uncertainty and low inflation depresses commodity prices, and we see a renewed equity bull market where stocks significantly outperform commodities.  Or, 2) the weakness in commodities is signaling trouble on the macroeconomic horizon, as global growth stagnates and we all flirt with another bout of global deflation (which would better explain gold’s weakness than just money flows).  Scenario No. 1 is equity market positive, scenario No. 2 is very equity market negative.

I don’t know which it is, but it is one of the two.  I hope it’s the former, but I fear it’s the latter– as I still can’t get it through my head how we all get global economic growth without stimulating massive inflation across the globe.  The path out of this multi-year, global economic malaise is through economic growth and inflation—that’s what we should all want to happen—but commodities are telling us it isn’t happening.  And, while I hope we’re embarking on an 1980s-style equity bull market, I just can’t see how at this point.


A look at the Most Obvious Trend in the Bond Market


Currencies & Bonds

The “hawkish” Fed minutes were the main driver of trading in both Treasurys and the currency markets yesterday, as the thought of a dial-back of accommodation led to lower Treasury prices and a higher Dollar Index.

Treasurys declined sharply (30-year down 0.77%) and of note the decline accelerated throughout the afternoon despite a decently well-received 10-year Treasury auction that saw a bid to cover in line with recent averages despite the lower yield.  But, Fed minutes trumped demand for Treasurys yesterday.

In currencies the Dollar Index rallied 0.3%, and was higher against the euro, pound and yen (which continues to inch closer to 100 yen/dollar).

Looking at the commodity currencies, the Aussie dollar continues its rally, rising to two-month highs in reaction to the stronger Chinese import data (that’s positive for Australian raw material exports).


Steepening Might Be the Most Obviously Trend in the Bond Market

Of note in the bond market yesterday was an article in the WSJ (link here) that focused on the fact that Bill Gross was bullish on the 10-year Treasury, an opinion based solely on the fact that “In this environment, and ever since 2008, an investor needs to buy what central banks buy before (central banks) buy them…..In this case, since its JGB’s, an investor needs to buy what Japanese institutions will buy.”

That logic, I believe, is sound, and this is coming from one of the bigger long-term Treasury bears out there.  But, while I agree with Gross’s call on increased demand for 10-year or shorter-duration Treasurys, I still think the trend in the 30-year is lower, so this presents an interesting spread trade idea—Long TBF (I-Shares Short 20+ year Treasury) and also long IEF (I-Shares 7-10 year Treasury).  So, you’re short the long end of the curve, and long the “belly” or medium part of the curve.

Or, put another way, if we have long dated bonds underperforming while shorter and medium-term bonds are well supported, we should see a significant steepening of the yield curve, and oddly enough there is an ETF for that too:    STPP (IPath US Treasury Steepener ETN).

Now, this thing is totally trade by appointment and it’s an ETN, but it’s at pretty much all-time lows—so something to consider as another way to play the bond market  where the BOJ is now a major influence.


What to Watch in Economics for the Week Ahead


This Week
Compared to last week, things will be relatively quiet on the economics front this week. The most important domestic report will be retail sales on Friday. Given the payroll tax hikes, increased healthcare costs and sequester, markets are concerned whether or not the consumer can hold up. So far, the data has shown the consumer is still spending, but the employment report has people nervous, especially after the retail industry dropped 24k jobs in March.

Second in importance this week will be the Fed Minutes from the most recent meeting. The market will be looking for more clarity regarding when QE purchases will be scaled back, although given that the last meeting was an extended one with a press conference and growth projections, I’m not sure there will be much gleaned from the minutes that we don’t already know.

Finally, jobless claims will be watched Thursday, specifically to see if that big Easter-related jump in claims is revised down. Given the soft monthly jobs report last Friday, this will take on even greater significance.

Looking Internationally, by far the most important report this week will be Chinese CPI (released tonight). The main concern in China remains rising inflation, in that it could continue to force additional fiscal tightening from Beijing. Given the stagnation in Europe, the global economy needs China to continue to see growth accelerate, and that will be hard to accomplish if inflation is running too hot.

Things quiet down in Europe this week, as there isn’t a lot of economic data. EMU Industrial Production (Friday) is the highlight, and German IP (today) will also be watched—but those reports, even if they are better than expectations, won’t be enough to stem the growing concern that the EU economy is once again contracting.

Central Bank Decisions

Central Bank Decisions

Bank of Japan

The bar was set pretty high for the BOJ coming into yesterday’s meeting.  Investors were expecting a lot of additional monetary easing, but seeing as the yen had already declined significantly, most assumed that the “dovish” results of the meeting were priced in.  They were wrong.

New Bank of Japan Governor Kuroda promised earlier in the week to do everything he can to break deflation, and he stuck to his words.  Without getting into the weeds of the fiscal details, the Bank of Japan has put its monetary accommodation into overdrive.

  • The Bank of Japan is going to specifically try to inflate asset prices (stocks and bonds) by increasing the adjusted monetary base (i.e. printing money) at a pace of 60 to 70 trillion yen annually over the next two years, compared to an increase of 13.4 trillion yen in ’12 and 15.6 trillion yen in ’11.
  • Additionally, the BOJ will start buying massive amounts of long-term government bonds (more than doubling the current pace of 20 trillion worth of bonds to 50 trillion).
  • Finally, the BOJ will increase the amount of ETFs it is currently buying by 100% (from 500 billion yen to 1 trillion yen).


I’m as big a Japan bull as anyone I know – starting from when I first pointed out the bullish trend emerging last fall with the election of Prime Minister Shinzo Abe.  In an investment landscape that is very conflicted and uncertain, the Japan bull market in equities was and is one of the most clear and powerful trends in the market.  But, as much of a bull as I was, I never would have dreamed of this type of historically aggressive monetary policy.  The bottom line here is that I believe that Japanese stocks are heading much, much higher, and the yen is heading much, much lower.  I’ve made the analogy often that buying Japan now is like buying the S&P 500 at the start of the QE program – well now it’s like buying it at the start of a QE program on steroids.  Long DXJ remains my top idea in the markets today.

Don’t Forget About the DOW

Interestingly, the Dow was a big outperformer on the day (up .76%), and usually when that happens there is one stock that is up several percentage points that skews the average.  Interestingly, that was not the case on Monday, as the strength in the Dow was evenly spread across many of the index components (TRV, The Travelers, was the best performing stock in the index up just 1.79%).

The Dow is now up 5.76% for the year, about half of the S&P 500.  The reason for this underperformance has to do with the sectors that have rallied the most year to date (Tech and Financials) which are more heavily weighted in the S&P than in the Dow (plus the Dow doesn’t have AAPL).

But, the outperformance today should be noted.  If we are heading into a period of concern/weakness in the markets, the sturdy, somewhat stodgy, industrial companies in the Dow, with strong cash flows, good yields, and decidedly less economically sensitive businesses, will outperform.

If investors are concerned about the market trading like it’s 2011, then perhaps it’s helpful to look at what worked in 2011.  Keep in mind, in 2011 the Dow finished up 5.5%, while the S&P was flat, and the NASDAQ fell 1.8%.


Steepening Yield Curve a Bullish Sign for Bank Stocks

As you probably know, the banking sector has been one of the best performing of the year (up 28% year to date). I think it’s safe to say that the banks have probably become a bit overbought here, and that a correction of some sort is due. So, if you’re not already long the banks, it would be foolish to buy them here.

But, that short term overbought situation aside, one of the things that has been happening lately, that is very bullish for banks, is that the yield curve has been steepening for the first time in a while.

The difference in yield between the 10 year government bond and the two year government bond has risen sharply so far this year, and that speaks directly to banks “Net Interest Margin.“

As you probably know, banks make money by borrowing short term at low rates, and lending long term at high rates. That difference is called the Net Interest Margin, and that’s the profit the bank earns.

Well, as the yield curve steepens, the net interest margin of banks increases. So, despite the potential of a decline in the short term, the underlying fundamentals are turning more positive for banks, and a decline in the banks should be viewed as a long term buying opportunity.

Finally, while a steepening yield curve is bullish for bank stocks, there is actually an ETN that you can buy that actually rises as the yield curve itself steepens. The ETN symbol is STPP. Seems like there’s an ETF (or ETN) for everything these days.