There is no denying we are moving into the eye of the storm, with the market having merged into one giant consensus trade. That trade is of course long USD, short commodities and US treasuries (at least shorter term maturities).
Perhaps the biggest divergence has been in the S&P 500 and ASX 200, which up until today has ground higher, while the traditional leading indicators – such as the US yield curve, credit spreads and the Baltic dry index – push lower to worrying levels. Being long developed market equities continues to work though (and at least for now) and one just has to look at the MSCI world index/CRB commodity index ratio. Here, the ratio has increased 26% this year to stand at 9.2861x and is effectively at the highest levels since 1999. This must speak volumes on investing in commodities as an asset class.
Looking at positioning, (a key input for short-term trading along with price action, trend, sentiment, volatility, market internals and correlation) we can see a fairly definitive stance from speculative funds. According to the weekly Commitment of Traders (CoT) report (where money managers have to report weekly futures positions to the CFTC), the market has a net short position in brent oil of -141,000 contracts (the most since October 2014) and copper -29,000 contracts. Despite the net position in gold being long 34,000 contracts, this has fallen staggeringly since October and is the least net long since April.
In FX markets, according to data reported to the CFTC in the weekly CoT report, speculative funds hold an aggregate position of $46 billion, which is not far off the record highs seen in January. Net short holdings in EUR/USD (at -164,000 contracts) and AUD/USD (-66,464 contracts) are looking especially stretched. The current net USD positioning is similar to IG’s client holdings, where 72% of all open positions are net long the USD index.
If we think about risk to reward, we know the world is balanced in one direction and one just has to look at the technicals which compliment the positioning. LME copper held a 9-day RSI of eight in Asian trade (as far as I can see this oscillator has never been lower), nickel at 10, and zinc at 21. This is clearly a reflection of the aggressive rate of change behind the price movement, but they also represent grossly over-sold conditions. Perhaps this is a reason why we are seeing some buying coming into the commodity complex today, although the same can’t be said in the Australian resource sector, where buying activity is very limited.
There is no doubt the falls in commodities have been heavily traded by momentum-based funds (CTA’s) and conditions for these players have been almost perfect. There simply haven’t been any buyers and commodity futures have been easy to push lower. Whether it’s the USD index hitting 100 or the Fed’s preferred trade-weighted USD moving to a new 12-year high, this has hurt commodity prices. With EUR/USD falling aggressively, there has been a perception that the EUR weakness has had positive ramifications on European exports. This will in-turn hurt China’s export volumes as the imported goods have to come from somewhere and global corporates have been achieving significant purchasing power as opposed to European goods. There is a bet against old China (industrial), while domestic traders, if they are buying Chinese markets, are buying ‘new China’ (internet, media or on-line retailing for example). Then there is a supply/demand argument, with names like Chinalco cutting surcharges and Caterpillar consistently providing a discerning outlook.
The question is: Has this view gone too far?
Would there be ramifications from a disgruntled China if the Chinese yuan comprised a very small weight (below 8%) within the Special Drawing Right (SDR) basket? A longer-term devaluation of the RMB is expected by the market, but traders are expecting a slow drift lower and not aggressive action. The International Monetary Fund (IMF) board meeting is on 30 November.
What if the market shows disappointment should the European Central Bank cut the deposit rate by a mere 10 basis points to -30 basis points on 3 December? Just look at the German two-year bond, euribor or three-month libor, – traders want to see a negative rate closer to -40 basis point. Will we see a ‘sell the rumour, buy the fact’ scenario play out in EUR/USD?
What if OPEC cut production in the 4 December meeting at a time when traders are significantly short brent and WTI? What would a change in energy trends mean for headline inflation expectations when it is likely to start creeping higher in the coming months because of base effects?
What if Janet Yellen’s speech to the Economic Club (Washington) does not suggest an urgency to hike the funds rate in December? This is a low probability, but the market will be super sensitive.
What if the upcoming US payrolls report on 4 December comes out at the low-end of estimates (consensus is 198,000 jobs but ranging from 267,000 to 130,000 jobs)? A really low number will see traders look to hedge and unwind positions if heavily exposed to the big consensus trade (as detailed above). The Fed would be loath to hike in December if the implied probability is below 50% and we could feasibly see the probability below 50% on a weak payrolls report.
To summarise, the world is caught in giant consensus trade and judging by the VIX index or even one-month implied volatility in EUR/USD, traders are expecting the playbook to go exactly to plan. I am not saying this has to change, but we need to be aware of the risks as we enter a period where the whole investment landscape can change if the market script is not followed to the tee.