- The spring rally in key commodities has turned into a sell-off.
- The dollar’s upswing could soon run out of steam.
- Gold is fast approaching critical support.
Commodity markets are always volatile, but this year has been particularly difficult to navigate. Easy-money trading — inflation that drives commodity prices higher — worked earlier this year, but lately it has spiraled out of control due to restrictive rate hikes.
A pullback from the early year highs is not unexpected. Historically, baskets of goods perform best when inflation is rising because demand exceeds supply. A year ago you couldn’t visit a news site without seeing an article about a red hot job market or a collapsing supply chain. This year? Not as much.
An unprecedented tightening in 2022 has replaced an unprecedented easing in 2020. As a result, the economy is in a not so good shape while we wait for the rate hikes to take effect.
In short, we’ve seen a history of two tapes in the futures market this year, begging the question, “What’s next?”
At times like these, I turn my attention to Real Money Pro’s Carley Garner. In “If You Can’t Take the Heat, Get Out of the Futures Market,” Garner breaks down what’s happening in currencies and commodities and shares her perspective on oil, gold and the US dollar.
Here is Garner’s article in its entirety:
“Being a futures broker has nothing to do with how the industry was portrayed in ‘Trading Places,’ that 1983 film starring Eddie Murphy and Dan Aykroyd. Most brokers and brokerage professionals don’t wear smart suits or come to work in limousines. We don’t enjoy chef-prepared meals at a chic oak dining table while casually reviewing the day’s market movements.
In fact, it’s an industry of grunt work, grit, and gut checks. Many of us eat two meals a day at our desks as we strive to help our customers avoid disaster. it’s anything but glamorous. The commodity brokerage industry delivers the highest highs and the lowest lows; one cannot attain the former without suffering from the latter.
For me, 2022 felt very much like a repeat of the financial crisis. The era created prosperity for those who gamble outside of the odds, but proved painfully dire for those who gamble in favor of the odds. Although the stock market has so far managed to avoid the same fate as the 2008/2009 bear market, the intense volatility and desperation in peripheral assets such as currencies and government bonds have been far more challenging.
This was due to credit default swaps and bank leverage during the financial crisis. This time, leverage risk was introduced into the system by the Fed (too low interest rates for too long and irrational buying of mortgage-backed securities) and politicians (too much stimulus). The credit default swaps of 2022 are exchange traded funds in my opinion. Leveraged ETFs and commodity futures ETFs have added an element of volatility that was unfathomable before the retail boom and the creation of products for new trader demographics. Leveraged and Commodity ETFs are packaged products sold to retailers to mimic leveraged products (such as futures contracts) or a specific commodity. In either case, they require constant rebalancing and dealing with cash inflows and outflows from retail traders, which the futures markets are not always able to absorb in a civilized manner. This process is further exacerbated by algorithmic trading, which stacks into trends and always pushes them further than they would otherwise. Of course, people are unpredictable and have been known to cause unnecessary volatility when they react emotionally to price changes, but 2022 volatility is different from 2008/2009 volatility. This is the new normal and we must adapt.
Let’s take a look at some of the key markets that have contributed to the chaos we are seeing in the markets today.
commodity prices
The commodity boom and bust of 2021/2022 began with copper, wood and natural gas. These were the stories pointed out by inflation hawks. Each of these commodities rallied strongly in 2021, leading to disruptions in manufacturing and housing (copper and timber) and rising input costs for households, farmers and service companies (natural gas). The world watched in awe as the prices of these commodities, and eventually others, skyrocketed, but they don’t garner the same amount of fanfare as they trickle down. Consumer-level inflation remains high, but the key factors contributing to this inflation are being traded as if the narrative were about deflation. This could be a sign that the Fed and the nature of commodity markets (high prices cure high prices) are working as planned.
Lumber futures have eliminated the entire post-Covid rally and copper is at levels not seen since 2020.
Natural gas has managed to stay afloat due to geopolitical issues in Europe, but in the last few trading sessions gas is down around 35% and according to the monthly chart the market is in danger of falling below the critical $6.50 support. If this occurs, a breakdown towards $4 is a real possibility.
Oil futures are about $55 off their 2022 peak. In our view, oil at $130 a barrel was a reflection of oil’s fall below $10 in spring 2020. Such prices are unsustainable and are likely to be exacerbated by commodity ETFs (in our view according to these products are detrimental to pricing and lead to chaos). ). Anything is possible when it comes to commodities, but the pendulum is swinging strongly in both directions. Although most speculators have liquidated their long oil positions, leaving room for a temporary breather in selling, the long-term outlook for oil is $60.
victim of inflation
The main victims of inflation have been government bonds, precious metals and any currency other than the US dollar. When investors start reacting to lower commodities with the same conviction they reacted to higher commodities, mean reversion will be startling. There were obvious and vicious cycles of buying commodities and selling government bonds in early 2022, but we haven’t seen this work in reverse as oil and natural gas are making their way down.
In the case of gold, higher interest rates and a near-parabolic dollar rally driven by runaway inflation and the US Federal Reserve’s response to it have forced speculators to liquidate most of their long holdings. Throughout history, speculators have tended to long gold all the time; they are seldom net short in the gold market. However, as this long position has shrunk towards net flat gold, we have seen strong rallies as speculators re-enter the market. From where we are, this turning point may be near.
The pain in the gold band is palpable, but the bulls need to keep an eye on two potential reversal levels: $1,630 and $1,580. We’d rather not see the latter, but we can’t rule it out. If it does, it would likely be a quick probe down to blow out week hands and sell stops. In any case, maybe somewhere between $1,630 and $1,580 is seen as the last chance to get a ticket to the party.
While inflation and interest rates are the headlines of the year, the results of these two factors for the US dollar are dominating global markets right now. Last month we posted this chart with the thought that the US dollar could set a double top to forge a final hurray rally into the 113.40 area.
We were wrong on the double top, but we stand by the idea that the weekly trendline resistance will hold the first time and maybe for several years to come. A weekly close below 113.40 would confirm a reversal, but a weekly close above 113.40 suggests we are close to the next stop (all-time highs near 120.00). I think we can all agree that this is undesirable and would be bad for the global financial system.
Go with the grain, watch the buck
Keep an eye on the US dollar and grain markets (corn, soybeans and wheat). Food prices and extremes in the forex markets are the last remnants refusing to succumb to gravity. When they finally blow up, the normalization of the bond market will be next, followed eventually by equities. That said, even if that view turns out to be correct, it doesn’t mean the trade will be a picnic. Volatility will be intense and traders will be bowled over as markets shift narratives. Be careful out there.”
The intelligent game
my recording? US dollar strength has helped keep dollar-denominated commodity prices, including oil, in check. Gold has an exceptionally high negative correlation to the dollar, so it has been hit particularly hard by its strength. Similarly, risky assets have suffered as 29% of the S&P 500’s earnings come from overseas markets. Headwinds have been most severe for technology stocks, as 57% of their sales are international. So from here, pay close attention to the dollar as its direction is probably the best clue as to what happens next in these futures markets.
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