Ahh, the good old Fed. You can always rely on the world’s most important central bank to set off some fireworks when it discusses interest rates. Overnight, markets went a little loopy as traders were clearly not positioned correctly going into the Fed’s announcement.
That is, the expectation was for the Fed to confirm that interest rate rises in the US would start as early as June. But it worded the statement in a way to suggest that while a June hike was possible, it was by no means a certainty.
It all depends on the strength of the data, notably employment and inflation. Given inflation (or at least the narrow definition of it that the Fed uses) remains well below the Fed’s target, markets are clearly betting on a rate rise coming in later rather than sooner.
That gives more time for speculation! But from now on, data points on inflation will be the market’s next plaything. So expect plenty of volatility around these releases.
The US dollar index dropped significantly on the Fed’s statement. It’s still in a very strong uptrend though, so I wouldn’t be calling a top here. But it could have a decent pullback.
As a result of the fall in the dollar, commodities and all things non-US dollar rallied. Oil jumped and gold rallied nearly US$20 an ounce. Equity markets loved it too, with all US indices surging post the Fed’s announcement that it would take its sweet time in raising rates. The Dow and S&P 500 both finished up over 1.2%.
The Aussie got a nice boost too. It surged well over US$0.78 at one point, before finishing the trading session at 77.83 US cents.
These sharp movements, especially in the Australian dollar and commodities markets, suggest a short-covering rally more than anything else. Going into the announcement, hedge funds had cut their bullish bets on commodities to very low levels.
According to a recent Saxo Bank report on hedge fund positioning in the futures markets,
‘Commodity traders continued their dramatic exit from the sector which remains under sustained pressure from the rising dollar, rising supply and sluggish growth among some of the biggest consuming nations.
‘During the week ending March 10, hedge funds cut their net-long exposure on 24 major commodities by 26% to just 332,000. In less than one month, the exposure has more than halved and this time last year the net-long were above 2.1 million lots.’
In other words, this time last year investment funds were ‘net long’ 2.1 million futures contracts in the various commodity markets. That position has now shrunk to just 332,000 contracts.
It’s this type of bearish positioning that sets markets up for vicious counter trend rallies. Traders were obviously reluctant to own commodities or non-US dollar currencies going into the Fed announcement. But when the Fed’s words were more dovish than expected (who would’ve known…I mean really!) traders scrambled to buy.
This could well be the start of a bottoming process for commodities…or it could just be another mini rally in quite a pronounced downtrend. You’re not going to know for another month or two…or maybe longer.
So did anyone not get an invite to the Fed’s punchbowl spiked party? As far as we can tell, poor old iron ore was tucked up in bed before the party even started.
The benchmark iron ore price dropped 2.6% yesterday to US$55.48 per tonne. It may get some sort of Fed induced reprieve in today’s trade but I doubt it. The terrible fundamentals of the industry are overwhelming.
There is just too much supply coming on line at a time when Chinese steel production has peaked and likely to fall in the years ahead. China’s desire to rebalance its economy away from commodity intensive growth means replicating (let alone growing) the type of iron ore demand seen in recent years will be nigh on impossible.
But iron ore expansion plans all came from US$150/tonne-plus prices and the iron clad assumption of a US$120/tonne price floor. Turns out it was more trap door than price floor.
Be that as it may, the expansion plans received approval and now, a few years later, a flood of red dirt is hitting the market. And don’t forget, Gina Reinhart’s massive Roy Hill mine hasn’t even started producing yet.
You’d think low prices are supposed to curb production, but that’s not how it works in the short term. In the short term, companies try to justify their investment plans and produce as much as they can to keep costs down and their heads above water.
The only thing that will bring balance back to the iron ore market is prolonged low prices. That means long enough to knock out all the small, marginal producers. While there will be the odd price rally, expect the downward trend to continue and then bottom for years.
Then, Rio, BHP and Brazil’s Vale will be about the only major global producers of iron ore. Fortescue may manage to hang on, but it will need a lot of luck and patient creditors. More than likely, equity holders will get wiped out and bond holders will get the proverbial pennies on the dollar back.
So I wouldn’t be looking to pick the bottom in Fortescue here. There’s just too much risk for not enough potential reward.
If you want to play it short term, you’re better off punting on the continued rally in bank stocks. They might be overvalued and will come a cropper at some point, but that doesn’t look like happening anytime soon.
Or you could start building a position in a bombed out sector that, unlike iron ore, looks to have turned the corner. It’s a slow process, and one that not many investors seem to have noticed right now. But it’s happening.
Check out this report to see what I mean.
for Markets and Money