July Weakness Fueled By Reflation And Virus Variants

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The commodity sector has faced a challenging beginning to a new quarter and this past week all sectors apart from precious metals traded lower, led by renewed losses across the agriculture sector, while in energy the prevailing positive narrative paused in response to a brewing OPEC feud clouding the outlook just as the spread of the delta virus variant sapped the general level of risk appetite.

During the first half of the year, physical as well as investment demand for raw materials surged on the prospect of a strong growth comeback, rising inflation and governments stepping up their efforts to combat climate change. An effort that will require a massive amount of industrial metals and investments.

However, during the past few weeks the rally has started to stumble, with improved weather developments sending the prices of key crops sharply lower, OPEC-fueled uncertainty hurting bullish oil bets, and signs the post-pandemic recovery in China has started to cool hurting the short-term prospects for China-centric commodities such as copper, iron ore and steel. A development that on Friday led the People’s Bank of China to cut its reserve ratio requirement, or RRR, by 0.5% and a move that will inject RMB 1 trillion liquidity into the system to support small and medium sized enterprises as well as growth in general.

In addition, we are seeing the U.S. Federal Reserve move in the opposite direction as FOMC members have started to discuss the tapering of debt purchases used as fuel to stimulate the economy, while at the same time successfully (so far) talking down the risk of runaway inflation. These developments, together with a market still flushed with cash, helped send US Treasury yields sharply lower this past week with Ten-year U.S. Treasury yields at one point hitting 1.25%, the lowest since February, thereby supporting a positive week for gold.

As we enter the summer holiday season across the Northern hemisphere it is also important to note that markets during the next 4 to 6 weeks will be faced with the prospect of lower liquidity potentially driving outsized market reactions to news that triggers a change in the technical and/or fundamental outlook. Examples of outsized moves were already seen this past week across all three commodity sectors.

Agriculture: Major setbacks in corn and wheat helped drive the grains sector sharply lower just one week after weaker-than-expected U.S. acreage and stock reports helped drive the sector higher. Overall, the year-long surge in global food prices paused in June after the UN FAO reported the first drop in 13 months in its Global Food Price Index. It dropped by 2.5% in June with the year-on-year surge easing to a still elevated 34% from 40% in May. The decline was driven by a near 10% slump in edible oils, such as palm, soy and sunflower oils, while the mentioned fall in corn and maize also supported the decline.

Corn was the biggest loser this past week in response to improved weather conditions across the U.S. Midwest and equally important on speculation that China’s import demand has peaked with local corn futures trading near the lowest levels this year. This is in response to rising Chinese production and expectations that demand for the grain towards animal feed will decline as loss-making hog farmers have stopped expanding herds. A recent USDA briefing from Beijing estimated the country’s imports in 2021-22 will reach 20 million tons, well below the department’s official 26-million-ton forecast.

The CBOT Corn future for December delivery has broken downside support to trade below its 100-day moving average for the first time in 11 months. Further weakness could see it target $5 next followed by the 200-day moving average at $4.72. 

Energy: Crude oil traders and investors were left somewhat confused after seeing the price of crude oil slump by close to 8% immediately after WTI reached a seven-year high and Brent the highest level since late 2018. These developments occurring despite the prospect for an even tighter global oil market after the UAE derailed plans by OPEC+ nations to increase production from August to December by 400k b/d per month.

The combination of OPEC-fueled uncertainty and a rapid rising virus count, once again raising questions about the demand growth trajectory, has led traders and investors to cut positions first and ask questions later, and perhaps those questions may now not be asked until late August when most have returned from their annual summer holiday. In addition, a prolonged period without a deal could drive an increased amount of noncompliance or even a renewed price war should producers opt to boost output unilaterally. The feud between Saudi Arabia and the UAE could in a worst-case scenario lead to a breakup with the UAE pursuing an agenda of selling as much crude as possible while demand remains strong.

Our base case scenario is one that remains supportive for oil prices as a rising supply deficit will require higher production from a small group of producers with spare capacity available, most noticeably Russia, Saudi Arabia and the UAE. Not least considering the current lack of response from key non-OPEC producers such as those in the U.S. who are still focusing on maintaining discipline. However, in the short-term, over the coming weeks the potential risk of rising price volatility and renewed focus on the spread of the COVID Delta variant may prevent the price from returning to its recent highs.

Crude oil’s year-long uptrend has yet to be challenged and it is likely to stay that way unless the OPEC feud leads to a breakdown which could see producers aggressively open the taps. For now, the WTI range is between $70 and the now double top around $77. 

Metals: Gold spent the week trading rangebound within a $1795 to $1815 range, while a supportive drop in US Treasury yields had a limited impact as it was driven by another deflation of the reflation trade following the publication of minutes from the mid-June FOMC meeting. Other metals, such as copper, silver and platinum all struggled with policy makers around the world from the U.S. to China flagging risks to economies and persistent COVID variants fueling doubts about the outlook for growth.

However, the People’s Bank of China’s well-flagged decision on Friday to cut its Reserve Ratio Requirement by 0.5% helped sooth some of the build-up concerns while also softening the dollar. The move supported a small recovery in copper while silver rose after hitting a 3-month low in its relative value to gold earlier in the week. This coming after the XAUXAG ratio almost touched 70 ounces of silver to one ounce of gold.

Gold’s credentials as a hedge against unforeseen developments has, in our opinion, strengthened during the past month. Following the mid-June FOMC meeting, the market has increasingly priced in the prospect for moderate inflation. With this in mind, we believe gold has major upside potentials should the global recovery not play out as anticipated or inflation begins to move above expectations.

Gold’s correction last month has exceed what could be expected given the movements in the dollar and yields. It helped attract fresh short selling, and these are unlikely to get reigned back in unless the price manages to recover above $1815, and more importantly $1834, the 50% correction of the June correction.

Ole Hansen, Head of Commodity Strategy, Saxo Group