No fools rushing into commodities

We continue to hold the line around our macro themes for the first half of 2015 and if anything the strategy thematics have strengthened over the past week.

Oil
Source: Bloomberg

The points below remain the rules we are using to create our trading strategies:

- USD strength – specifically leveraged to the USD earnings or direct currency exposure

- Bond yields remain at record lows due to the record low cash rate environment. Institutional funds continue to move into high equities with high yield – Yield trade

- Central bank taps are still well and truly open – even with the Fed looking to tighten, easing is still at record levels from all corners of the globe

- Global inflation remains at the bottom of central government expectations and disinflation remains a real concern

- Growth remains elusive across the world

- Commodity prices remain locked in bear markets – the cyclical bottom is not at an end

The contrarian call currently is to sell out of the yield trade to begin to positioning for the reversal in the cyclical growth names. The reasoning is the global liquidity taps will flood the global economies promoting spending and global growth.

I understand this standpoint - I do see the central bank liquidity flood creating positive change in the back half of the year. However, there are still several hurdles to get over in the coming six months before I would be switching strategy and positioning to a growth profile.

First – Supply

Yesterday saw Dalian iron ore future limiting down to a new record low of CNY394 a tonne before settling at CNY403. The iron ore spot price in Qingdao fell to a new record low for the port of US$51.35 a tonne - a ten year low for the price in general. This is despite the news from People’s Bank of China and the central government on Monday that they are relaxing monetary and fiscal policy to support the housing market.

The supply side of the iron-ore market is still ramping up. Australia and Brazil continue to flood the market at any cost. Even if demand ticked up the supply side will keep prices depressed.

However, it’s not just iron ore suffering from this shift. Bulk commodities as a whole are struggling to attract demand. Steel production in China is at its lowest levels in almost 25 years. The normally stable metallurgic (met) coal demand used in the catalytic proceeding of steel is starting to see oversupply issues as demand for steel plummets. On the supply front, coal is now facing similar issues to iron ore, as additional countries (specifically India) look to enter the supply chain even as demand is falling.

Second – Stockpiling

This is a bigger short term risk, specifically in oil. Although supply demand in the global oil markets is believed to be sitting at equilibrium, stockpiling in oil is at records. The US is currently sitting on 495 million barrels of oil according to the last inventory count. Any creeping demand will likely see stockpiling being released which will keep the price in oil underperforming until the back log is cleared. The return to US$80 a barrel is still a way off.

This is why I am convinced that the cyclical bear market in commodities has not bottomed. There is a real possibility of a further down leg as stockpiling and the oversupply hits the market.

Therefore, hold the line on the yield trade. Yes it’s crowded and yes it will unwind and quickly when it ends. However, it is far from over. The intermarket market is pricing in a 68.2% chance of a 25 basis point cut next Tuesday, the swaps market is higher than that at 73%. Europe and Japan are only going to ease policy further in the next 12 months meaning the trade won’t be slowing soon.

Being a contrarian is tempting. However, breaking strategy would go against my trading rules and therefore I’m holding the line on the trade for a few months still. I’ll review this view come the end of May.

Ahead of the Australian open

The first day of the second quarter looks to be a negative one. We are calling the market down 32 points to 5859. With iron ore at decade lows positioning for the quarter is going to start here.

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