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Recession speculation comes for commodities

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Good morning. Another odd and volatile day in US markets yesterday. The minutes of the Fed’s last meeting reflected a feisty central bank committed to rate increases. Treasury yields duly rose. Stocks, for some reason, rose sharply too — not at all what we would have expected in response to Volckery noises — before giving up most of their gains at the close. Markets are weird, and weirder than usual just now. Email us: robert.armstrong and ethan.wu.

Commodities and recession speculation 

The reversal in commodity prices in the past month is really something:

Oil is within spitting distance of its price before Russia’s invasion of Ukraine; wheat has hit it. Copper is at an 18-month low. If it keeps up, this trend should be — considered in isolation — excellent news for investors. Given the way energy and commodity prices seep into so many other prices, a sustained decline in commodities would take a big bite out of inflation, allowing central banks to tighten policy less aggressively, giving economies and asset prices relief.

But, in a tightening cycle, nothing can be that simple.

Complication one: the reason commodities are falling in tandem and at speed is because of fears of recession, which puts the positive effect on inflation in a bleak context. Complication two: falling commodity prices do not reflect an improvement in fundamentals, specifically an increase in supply. Instead, they reflect financial speculators’ shifting their positions in anticipation of a withering of demand that may or may not materialise.

The financial rather than fundamental drivers of the rout have been the theme of the FT’s coverage:

Although physical supplies of many raw materials remain tight, “hedge funds are taking their chips off the table, [they] are leading big liquidation flows”, said David Whitcomb, head of research at Peak Trading Research . . . 

A total of 153,660 agricultural futures contracts worth $8.2bn were liquidated in the week to June 28, the US Commodity Futures Trading Commission said in its latest report. This was the second biggest sell-off of long positions on record, according to Peak Trading Research . . . 

Bearish bets on copper currently stand at their highest level since 2015, according to Marex, a commodities broker with hedge funds net short 60,000 lots, or 1.5mn tonnes of the red metal, across all markets at the end of June, up from 4,000 lots at the start of May . . . 

Turning to the oil market in particular, I asked Amrita Sen of Energy Aspects whether any aspect of the shift in prices was based in supply and demand data. She was adamant: “No fundamental basis whatsoever.” 

Sen sighted two features of the market that indicated it remained extremely tight. The first is that the first and second-month contracts remained in extreme backwardation; that is, the front-month contract is unusually high relative to the second month. Refiners, running full tilt, are paying a premium for delivery now. Second, while the prices of Brent and WTI crudes, which are heavily influenced by traders, have dipped below $100 in recent days, regional crude prices that reflect what end users are paying have stayed much higher. North Sea and West African crudes are trading at very wide spreads to Brent, she noted. Paper markets and physical markets have come apart, in short.

Damien Courvalin of Goldman Sachs agrees, arguing that the market is actually getting tighter. He writes:

The declines in prices and refining margins since mid-June are now equivalent to the oil market pricing in an 1.1 per cent downward revision to . . . global GDP growth expectations [over the next 12 months]. We believe this move has overshot — while risks of a future recession are growing, key to our bullish view is that the current oil deficit remains unresolved, with demand destruction through high prices the only solver left as still declining inventories approach critically low levels.

Of course there is the possibility that recession will come, even as supply increases, and oil prices will continue to fall, as the speculators appear to be betting. Ed Morse of Citigroup was already propounding that view when we spoke to him back in March. He still holds it. The fact remains, though, that the speculative nature of the recent move opens up the possibility of a violent reversal that brings with it a renewal of inflationary expectations.

What if the Bank of Japan simply hangs on?

The Japan macro story hasn’t changed, because the Bank of Japan hasn’t changed. It’s stubbornly set on yield curve control: capping 10-year yields at 25 basis points, despite rates rising across the rest of the world. How long can it hold on?

Some bond investors are betting against the central bank, even as the BoJ buys bonds like mad, in effect telling investors “no, guys, we’re serious”. The bank, it seems, believes it has a shot at the consumer-driven inflation it has long desired, as opposed to the commodity import-driven inflation it currently has.

From the FT’s excellent Big Read on Monday:

Analysts are wondering just how much longer the BoJ can hold its course, as political winds shift and public unhappiness grows. But no path presents an easy way out. “Deflation has continued for three decades and price stagnation has become the social norm. The society as a whole does not tolerate rising prices,” says Kazuo Momma, the former head of monetary policy at the BoJ who is now executive economist at Mizuho Research Institute. “There is fundamentally no exit for the BoJ.” 

But what if the bank just keeps at it? The most common reply here is that political pressure from a weak yen will force a policy shift. This could happen. The weak yen is unpopular, and commodity inflation has annoyed even Japan’s penguins. But given how durable yield curve control has been since its 2016 introduction, it’s worth considering the other side of the bet. If rates stay pegged low while the yen stabilises, it could boost the once-popular yen-funded carry trade (ie, borrow at yen rates, collect yield at dollar rates), which never really recovered from the financial crisis.

Pelham Smithers at Pelham Smithers Associates, a UK-based Japanese research outfit, made a strong case to us yesterday that the BoJ won’t do much. The argument goes:

  • There is no inherent reason yield curve control must end. The BoJ can keep maintaining its yield cap by buying government bonds for the foreseeable future.

  • It isn’t obvious that lower rates and a weak yen are any worse for the economy than higher rates and a stronger yen (contrast that to the UK in 1992, where the government was stuck maintaining economically destructive high rates to prop up the pound).

  • What the BoJ wants to see, even more than positive consumer inflation, is real wage growth, which has been stagnant for decades.

  • Nominal wages have finally started to grow. Contractual wages in May rose 1.5 per cent year-on-year. That is lower than inflation and not sufficient — but it is new, promising and could encourage the BoJ to push on.

Here are what nominal wages have done since the coronavirus pandemic. Note that 2021 growth is inflated by base effects:

Line chart of Japan average monthly contractual wage % growth, year-over-year showing Here at last?

Will wages grow fast enough? 1.5 per cent growth is a good start, but 3 per cent is what the central bank seems to want. And can wages keep growing if commodity inflation subsides? Karthik Sankaran at Corpay makes this point well. He told Unhedged:

It’s good to have positive nominal wage growth . . . but you want to see that nominal wage growth becomes real wage growth, even when inflationary pressures turn down.

[If commodity import prices fall] is there the same pull from workers to have better nominal wage growth, and is there the same set of incentives on the corporate side?

With commodities now turning over (see previous piece), Japanese labour markets’ vigour is going to be tested, and soon. (Ethan Wu)

One good read

Can Ukraine win? Readable, reasonable stuff from the military historian Lawrence Freedman.

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