Commodity weekly: Rising yields a short-term threat to the commodity bull run

A super cycle is characterized by prolonged periods of mismatch between surging demand and inelastic supply. These supply and demand imbalances take time to correct due to high start-up capex for new projects, alongside the time needed to harness new supply. For example, in the copper industry it can be ten years from decision to production. Such periods often cause companies to postpone investment decisions awaiting rising prices, at which point it is often too late to avoid further price gains.

Previous demand-driven super cycles included rearmament before WW2, and the reform of the Chinese economy which accelerated following its accession to the WTO in 2001. Then, the period prior to the 2008 global financial crisis saw the Bloomberg Commodity Total Return index surged by 215%. Super cycles can also be supply driven with the most recent being the OPEC oil embargo of the 1970’s.

It is expected that the next commodity super cycle will not only be driven by recovering demand, but also heightened inflation risks at a time when investors will need real assets such as commodities to hedge their portfolios following years of sub-par returns. In addition, following a decade when investment in technology was preferred over hard assets there has been a lack of new supply lines. 

Whereas the early November vaccine news coupled with Joe Biden’s winning of the US presidency helped boost the sector, its current rally is almost ten months old (see chart above). Launched last April at the peak of the Covid-19 pandemic's first wave, the initial rally was driven by producers cutting supplies while China embarked on a massive stimulus program to reignite their economy.

Fund positions in key commodities relative to the one-year minimum and maximums showing the extent to which long positions have risen in recent months. Especially within the agriculture and energy sectors.

Strong commodity momentum in recent months, alongside emerging signs of tighter supply, helped attract increased  buying from speculators, some looking for inflation hedges while others simply jumped on board the momentum train. Whereas physical demand and tight supply look set to support prices over the coming months, if not years, the short-term outlook may become more challenging as “paper” investments have been exposed to the reduced risk appetite spreading from the recent rise in bond yields, most notably in real yields.

The emerging tightness across several commodities has, for the first time in seven years, helped create a positive carry on a basket of 26 commodity futures - a key development which has raised the investment appetite from investors seeking a passive long exposure in commodities.

While most of the rise is being driven by increased inflation expectations through higher break-even yields, rising bond yields are manageable.  During the past few weeks however, the rise in nominal bond yields saw real yields increase faster. This is worrying for the stock market because valuations among many so-called bubble stocks, with strong momentum but no earnings, suddenly look frothy.

A period of risk reduction driven by falling equities and rising volatility may become the catalyst for consolidation across the commodity sector: caution is warranted during that time. We firmly believe that inflation will eventually rise by more than expected, thereby stabilizing, or perhaps even sending real yields deeper into negative territory. However, with many individual commodity positions at elevated levels, and RSI’s pointing towards overbought markets, the prospect for a correction, or at best a consolidation, will probably prove beneficial for medium-term prospects.

Finally, a word on gold, one of the commodities that has suffered the most in recent weeks but which potentially also could be one of the first to benefit from the latest bond yield spike.  We have in updates and comments highlighted the risk that gold could suffer until bond yields rose to levels, that could force a response from the US Federal Reserve in terms of introducing measures to prevent longer dated yields from rising further.

During the past few months gold traded lower despite real yield’s staying close to -1%. That, however changed this week when 10-year real yields at one point spike to -0.55% without gold suffering a similar dramatic sell-off. These developments have brought yields and gold back in line. In the  short-term, gold remains at risk of a deeper correction should it fail to stay above key support at around $1760/oz.

The copper-gold ratio against US 10-year nominal yields highlight clearly the recent disconnect between rising copper prices indication a return to growth while bond yields stayed low. Under normal circumstances we are now seeing the two get more in line. But these are not normal times and given the risk of a Fed intervening in order to curb yields from rising we could see a major realignment. Primarily from much higher gold prices as real yields would slump as inflation expectations continue to rise.