Where Next for Commodities?

— Just what exactly is going on in the commodities markets? What’s behind the vicious pullbacks we’ve seen in the last week? Is it deteriorating fundamentals or the CME (Chicago Mercantile Exchange) squeezing speculators through margin hikes?

— Our guess is it’s probably both.

— As we discussed last week, the CME jacked up the margin requirements for silver even as the price of the metal was falling. Anyone would have thought the CME was trying too hard to push prices down. Last night, the target was margins on petroleum products. And prices across the energy spectrum duly fell.

— Is there any rhyme or reason to these margin hikes? Ostensibly, the idea behind them is to combat volatility. But that’s bull. More likely the margin hikes occur when certain wheels get very squeaky.

— So perhaps not coincidentally, Reuters reports that a group of 17 US senators recently sent a letter to the CFTC (Commodity Futures and Trading Commission) complaining about high energy prices. They want to agency to impose position limits on speculators, reducing the ability of participants to take massive bets on price movements.

— In a move typical of politicians, they only see problems when they affect their power base. With the US economy struggling and gas prices reaching all time highs, no doubt some senators are under pressure from their constituencies.

— And in a standard response to high prices, who better to blame than ‘the speculators’? But let’s just ignore the fact that the Fed Reserve actually provides the fuel for the fire.

— Could the CME have raised margins to push prices down and get the politicians off the CFTC’s back? Most certainly. For any of you that have followed the CFTC’s ‘investigation’ into position limits, this view won’t be surprising.

— For those of you who haven’t, a little background.

— For years, close followers of the precious metals markets have complained to the CFTC about ‘concentrated positions’ in the futures market. That is, a small number of large firms hold extremely large positions, which gives them the ability to unduly influence prices.

— A solution to this was to impose ‘position limits’ on firms. However in precious metals (gold and more so silver) there is a concentrated short position, i.e. a few firms betting on a fall. Therefore if the CFTC acted, there was a risk that precious metals prices could move materially higher. So the CFTC didn’t and doesn’t act.

— But now we see a push from the pollies to impose position limits in oil and energy. The difference here is that there are no doubt concentrated long positions that will come under scrutiny.

— It will be interesting to see how this plays out. The big investment banks have long resisted attempts to impose positions limits because it reduces their ability to influence market pricing and make easy money from…easy money.

— Just yesterday, Goldman Sachs revealed its traders managed to make money every trading day except one in the last quarter. Any independent trader not privy to inside information or with a high-frequency trading platform, or whatever it’s called, would say that’s impossible.

— In fact, we asked our resident trader, Murray Dawes, what he made of it. He told us he had already made something of it in a DR editorial earlier this week. For those who missed it, here it is:

High Frequency Trading (HFT) is getting a lot of attention at the moment but very few people really understand what it is.

A lot of the money that HFT traders make is based on front running other traders’ orders due to the sheer size and speed of the computing power

HFT traders wield.

Exchanges sell space in their computing nerve centres to HFT traders so their computers are positioned close to the hub and therefore shave nanoseconds off their execution speeds.

This ensures that they can front run other orders that they see coming from other exchanges or to dark pools.

So basically when you hear about investment banks making money on every trading day in the quarter (something that every trader worth his/her salt will know is impossible for any real trader) you should understand that they are basically stealing money by front running other traders’ orders.

— Anyway, the point is the futures markets are pretty much rigged to suit the house, like any well-run casino. And like any casino, only greed brings the punters in the door each day.

— While the commodities casino has been volatile, the underlying fundamentals aren’t too hot either. To be honest, they haven’t been for sometime.

— You’re either bullish on commodities because of China, easy money policies, or both. But China has an inflation problem and slowing growth, which means it will probably continue to tighten monetary policy in the months head.

— Elsewhere around the world (except perhaps Japan) monetary policy is going from ultra loose to just loose. Relatively speaking, this is a tightening of liquidity. And commodity markets rely on liquidity for their sustenance just as much as it relies on China building empty cities and apartment blocks.

— This ‘reduction of liquidity’ dynamic has major implications for the Aussie market and dollar. To give you an idea of where things might be headed, we asked Murray to give us his two cents worth on the ASX200 and the AUD/USD exchange rate.

— (BTW, Murray has just enhanced his trading system to target high-risk, high-potential return plays. If trading is your thing, click here for details).

— Firstly, the ASX200. How’s the chart looking Murray?

The ASX 200 is now teetering on the edge of the most important technical level of the past two years.  The point of control of the last two years trading range is 4700.  The 200-day moving average is at 4720.  If the ASX 200 fails below this key level you will see a very sharp fall similar to the one we saw in Mid-March with the first stop being 4500.  Below 4500 is where people would start to panic.

Source: Slipstream Trader

— Now, being a contrarian, value investor, we’re all for mass panic. It’s what makes stocks cheap. But central banks don’t like mass panic, especially not after spending trillions on trying to prop the market up. So it looks like the 4700 level on the ASX200 (and we’re very close to it right now) – Murray’s ‘point of control’ – will be quite a significant battleground between the bears and the bulls. Keep an eye on it.

— The AUD/USD exchange rate also bears watching. If commodities remain under pressure, the AUD going to US$1.50 camp might be disappointed. Here’s Murray’s take on it:

As far as the AUD goes it remains in strong intermediate uptrend but there are signs of weakening in the trend.  After last nights price action I would now expect to see the AUD pull back to $1.035-$1.05 but I would expect there to be strong support in that area and we may get a good bounce from there.  A failure to hold there would give targets to the 200-day moving average at parity.

— Our guess is that the AUD is headed lower for the time being. Of course all bets are off if The Bernank comes out QE 3’ing. But from a contrarian perspective, there has been way too much noise in the past few weeks about the strength of the AUD and weakness of the USD. Just about anyone who was on the trade was on it. When that happens, you can nearly always expect a pullback.

— And from a value perspective, try this little purchasing anecdote. We were looking for a new pair of trainers last week (usually a five-yearly event) and were aghast to find that our beloved Adidas Gazelles were retailing for $140.

— So we looked up some internet options. In the US, the retail price was just US$54. We also bought our little girl a nifty pair of Converse and, after shipping, still had change from the original $140. And it only took three days for delivery.

— Our one-dimensional conclusion? Australia is expensive, retailers’ margins are still healthy (but sales are poor) and the AUD is overvalued.

— We’ll be keeping a close eye on Murray’s point of control. A big break down through that area though would present some pretty good buying opportunities, we think. We’ll keep you posted.

Greg Canavan
Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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2 Comments on "Where Next for Commodities?"

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The cost of living isn’t affected by futures contracts. If speculators bet on higher gas prices, then if fuel costs go up and people don’t pay for it, it does down. If wheat is speculated to go down, and farmers can find plenty of people to sell to and so they take higher prices, then that is the contracts they will take. It’s nice to find out about the futures contracts being rigged like a casino. It further makes me want nothing to do with it. I already think it’s just gambling, no wonder so many people lose all their… Read more »
@Drew, there’s always a speculator there when you want one. The margin tap is turned on and the speculators are armed and the risk and carry trade is on. The margin tap is turned off and there she blows and the very one’s that armed them clip the ticket on the flight to safety. So few can carry the mug herd and so few can switch it off. They’re armed by QE. Look at the desperado banksters doing the job on the AUD-NZD, the brows have been sweaty as they’ve been forced to bide a longer time than their balance… Read more »
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