Commodity rally continues despite risk of a correction

Global markets, including commodities, continue to focus on the implications of the long awaited second round of quantitative easing from the US Federal Reserve.

So far the expected introduction of QE2 has hammered the dollar against other currencies raising fears that it could have a destabilising effect on the global economy.

The dollar has lost more than ten per cent in value versus the euro in just one month with only one out of 45 global banks predicting such an aggressive weakening over such a short period of time.

The effect on commodity markets has been very visible as precious metals continues to rally to new record highs as a cocktail of higher future inflation expectations combined with a weaker dollar lends the support required to break up into new territory.

The Reuters Jefferies CRB index has rallied strongly this past month with only a few markets moving in the opposite direction.

Several commodities from different sectors have shown double digit returns. The CRB index together with ten of the markets below has entered into overbought territory increasing the likelihood of a correction.

For now though the dollar holds the key to any near term movements.

It is also worth noting the discrepancies in performance within sectors with the most noticeable being corn which has outperformed wheat by nearly 19 per cent in just one month, more on that later.

Gold and especially silver broke higher this week with silver having rallied eight weeks in a row, the best run since 2006.

Real interest rates, which are nominal interest rates minus inflation, moved lower as QE2 and a subsequent weaker dollar had the market increasing the future inflation expectations.

Both metals are now technically very overbought, just like the dollar is much oversold, but until we have further news from the US Federal Reserve there has been no incentive to reduce risk in this sector with gold bulls looking for 1,400 an ounce as long the dollar stays weak. Support is located at last week’s low at 1,325 followed by 1,300.

The price of cude oil has now settled into its new range between 80 and 85 dollars. The strong rally from the 70 dollar low which was driven by the weakening dollar, strong Chinese demand and signs of a reduction in US storage levels came to a halt this week.

Traders were unwilling to add to their already long positions before seeing further clarification about QE2 and the subsequent impact on the dollar.

Opec ministers met this week and decided to keep production targets unchanged but at the same time urged member nations to comply with their quotas from December 2008.

Currently compliance averages around 60 per cent, somewhat higher than recent readings but still well below acceptable levels with Nigeria and Angola the worst offenders. They see the world market as being well supplied and prices are at levels that are acceptable to producers as well as consumers.

Money managers, such as hedge funds, nearly doubled their long position in WTI crude last week on the back of the recent move back above 80 dollars.

On that basis a move back below 80 dollars now carries the risk of long liquidation as many are unwilling to carry unprofitable positions for long.

Likewise a move above 84.50 should ensure that momentum carries it towards 87.15, the April high.

Turning to agricultural the USDA delivered a major shock to the market last Friday when they sharply reduced their forecast for corn and soybean output.

Hot August weather was followed by heavy rains which reduced yields across the US Midwest. What followed on Monday was the biggest one day rally in corn since 1973 as it rallied to the maximum allowed limit of 8.5 per cent just short of the psychological level of 6 dollars per bushel.

The USDA forecast that by September 2011 the corn stockpile will shrink to less than four weeks supply at 900 million bushels, the lowest in 14 years.

This week the US Environmental Protection Agency added further pressure to the supply outlook as they raised the cap on the amount of ethanol blended into gasoline from ten to fifteen percent for cars less than four years old.

The outlook for wheat, despite the lost output from Russia this summer, looks somewhat better and this has led to the near 19 per cent difference in performance this past month. Chinese demand, especially for soybeans remain strong. The recent dramatic rise of the price of corn could tempt US farmers to switch production away from soybeans thereby cutting supplies and boosting prices.

Technically corn has found resistance towards USD 6 per bushel and technical traders would like to close the price gap between 528.25 and 554.5 that emerge when the market spiked higher last Friday.

Talk of a global food crisis still lingers given the strong price rises among agricultural products these past few months.

The three S&P GSCI sub indicies covering food related products have rallied between 18 and 28 per cent year to date primarily due to adverse weather in the growing regions combined with the economic pick up among emerging economies which has led to a change in consumer habits.

Meat analysts forecast higher prices for beef, pork and poultry as producers will be forced to pass on higher feeding cost as the supply of corn and barley tightens.

The US cattle herd is the smallest since 1973 and breeding hogs are near the lowest ever count.

One of the reasons behind this reduction is due to the price of main feed ingredient which is 70 per cent above the 10 year average.

The writer is Senior Manager, Saxo Bank

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