Pain Mode – Commodities drop as FOMC deflates the reflation trade

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The commodity sector was heading for one of its biggest weekly losses since the early pandemic panic last March as the reflation trade deflated at a rapid pace after the FOMC signaled it would speed up its expected pace of policy tightening, thereby potentially lowering the risk of runaway inflation. Adding to these was continued efforts by the Chinese authorities to reduce inflation through curbing speculation and the hoarding of commodities. Finally, a stronger dollar also created headwinds after reaching a two-month high against a basket of currencies.

The FOMC produced a surprisingly large shift in policy this week, going from zero to two rate hikes by the end of 2023. A move from March when the median forecast was for no lift-off until 2024. The change suggests a significant number of Fed members are getting uncomfortable with the scale of the recent inflation spike. In the inflation forecasts, the core and headline numbers were adjusted sharply higher for 2021 relative to March, while core and headline inflation forecasts were raised by just 0.1% for next year, with no revision to the core reading for 2023, suggesting that the Fed still thinks current inflationary pressures will prove transitory.

The market ‘bought’ the Federal Reserve’s view on transitory inflation by sending the 10-year breakeven, or the anticipated inflation rate, down by 25 basis points. Combined with the stronger dollar, these developments put some of the major consensus trades in “pain mode”. Not least the reflation trade that together with strong underlying fundamentals had helped send commodities sharply higher during the past six to nine months. 

Crude: While pockets of weakness before the FOMC meeting had started to emerge across the metal and agriculture sectors, crude oil increasingly looked like the winner being supported by the combination of rising demand and OPEC+ keeping supplies tight. However, the derailing of bullish commodity bets after the FOMC meeting also managed to trigger some relatively light selling in crude oil. 

Up until then, speculators remained strong buyers in the belief downside risks were limited with OPEC+ keeping supplies tight at a time of rising demand. A demand growth that, according to the IEA, could rise to post pandemic levels late next year. Another weekly drop in US crude oil stocks failed to add further price strength with stocks of gasoline and diesel rising at same time. 

Post-FOMC weakness aside, the price found support in forecasts from the world’s top commodity traders, all speaking at the FT’s Global Commodity Summit, that oil prices could return to $100 over the coming years as investment in new supplies slows down with oil majors diverting capex towards renewables instead of continued oil and gas production. It highlights a potential rising dilemma where politicians and investors want to move towards renewables at a much faster pace than actual changes can be made. Thereby creating the risk of a supply shortfall before demand eventually begins to slow towards the second half of this decade.

What is clear, however, is that OPEC+ remains firmly in control while global demand continues to recover. At least until a time when non-OPEC+ producers react to increased revenues and profitability by boosting output. Actions with regard to production levels being decided at their early July meeting will be important in so far as it will send a clear signal whether the group, led by Saudi Arabia, seeks higher prices by keeping supply artificial tight or whether it prioritizes stability through increased production. 

HG Copper: Weighing on industrial metals were increased efforts by Chinese authorities to curb commodity prices. They ordered state enterprises to control risks and limit their exposure to overseas commodity markets, while the National Food and Strategic Reserves Administration confirmed recent rumors that they will soon start releasing national reserves of copper, aluminum and zinc which will be sold in batches to fabricators and manufacturers. High-grade copper was already suffering from the recent loss of momentum, which had driven a reduction in the speculative length to a one-year low, slumped to an eight-week low as short-term fundamentals showed signs of weakening as well. 

Despite emerging signs of a slowdown in Chinese demand, the long-term bull case for copper has not suffered a sudden death. Instead, the market reaction this past week highlights an important fact about markets and trading. Strong rallies tend to start in response to an oversold market and/or an emerging fundamental story which then can become self-feeding with speculators, who care little about what they trade, continuing to add exposure until the price actions tell them to stop and reverse. 

The resulting weakness this week was not triggered by a sudden drop in expectations for a tightening market over the coming years as inelastic supply struggles to meet surging demand from the electrification push, but instead investors cutting exposure as a result of negative momentum and the FOMC-led reduced focus on copper as an inflation hedge. 

Gold and silver suffered big corrections after the FOMC signaled it would speed up its expected pace of policy tightening. Markets were surprised at the scale of the adjustment to the Fed policy forecasts and Treasury yields backed up steeply while the dollar rallied. Despite seeing a strong US Treasury bounce ahead of the weekend, the damage to the technical price setup was done and both metals may experience a prolonged period, first finding support before consolidating.  

Gold remains the most interest rate and dollar-sensitive commodity, and while the dollar reached a two-month high, it was the movements in Treasury yields that spooked the market. While acknowledging inflation is rising, the Fed only lifted their 2022 and 2023 projections by 0.1% to 2.1% and 2.2% respectively. The firm belief that inflation will be transitory helped drive a 25-basis points reduction in 10-year breakeven yields, with real yields following an initial gold-damaging spike ending the week only up by 10 basis points to -0.81%. 

The yellow metal, which wasn’t trading robustly in the days leading up to the FOMC meeting, took a tumble from the simultaneous moves higher in dollar and yields. The break below the 200-day moving average at $1838 opened the floodgates with longs capitulating in droves while longer-term trend-following funds started to rebuild short positions. However, with RSI’s getting close to oversold, thereby signaling a potential slowdown in capitulation selling, the $1800 to $1770 range is now an area that needs to hold in order to avoid a return to the March lows. Relative safety is not achieved until a move back above $1825 or, more importantly, the mentioned 200-day moving average of $1838.

The grains market suffered its biggest one-day drop on Thursday since 2009 as expectations of crop-friendly weather in parts of the US Midwest and production upgrades from producers around the world helped sour the sentiment across the most short-cycled commodity sector. By that we mean the agriculture sector’s ability – weather permitting – to correct its supply outlook from tight to ample from one season to the next. 

Soybean futures, already reeling from the prospect for lower biofuel demand from US refiners, suffered one of the largest daily losses ever. Corn meanwhile was down more than 12% on the week before news of a five-fold increase in China’s May corn imports helped support calmer price action into the weekend. 

We are currently in a very weather-driven market, and just like we are currently seeing softer fundamental in metals, internal fundamentals such as the improved crop outlook does not justify a correction on this scale. Instead, the focus turns to financial investors many of which have been caught off-side by the sudden change signaled by the Federal Reserve on rates and inflation. Once the dust settles following this bout of long liquidation, all it may take to reverse the market higher will be another change in the short-term weather outlook. 

Ole Hansen, Head of Commodity Strategy Saxo Group