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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Head of Fixed Income Strategy
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Rising investment and physical demand drive oil towards 2021 high
Ole Hansen
Head of Commodity Strategy
Summary: Commodities of most colors continue higher on a combination of expectations for a post-pandemic growth sprint triggering supply bottlenecks, green transformation focus, weather worries and increased investment demand from speculators and investors enjoying the current momentum while seeking a hedge against the risk of accelerating inflation. One of main sectors benefitting from increased investment demand is energy, most noticeable crude oil.
What is our trading focus?
OILUKJUL21 – Brent Crude Oil (July)
OILUSJUN21 – WTI Crude Oil (June)
GASOLINEJUN21 - RBOB Gasoline (June)
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Commodities of most colors continue higher on a combination of expectations for a post-pandemic growth sprint triggering supply bottlenecks, green transformation focus, weather worries and increased investment demand from speculators and investors enjoying the current momentum while seeking a hedge against the risk of accelerating inflation. As a result the broad Bloomberg Commodity Spot index trades up 19% year-to-date with the year-on-year increase exceeding 60%.
The year-on-year rate of change has reached levels not seen for at least a decade, and with rising input cost forcing more and more companies to pass on the cost to consumers, we are increasingly seeing the risk of the current inflation spike not being the transitory phenomenon being touted by major central banks. Once inflationary pressures take hold it becomes very difficult to reverse and the risk being a self-feeding loop that may end up driving commodity prices even higher over the coming months and quarters, hence the increased focus on a new super-cycle.
Most of the commentators primarily focus on rising demand as the main reason behind the continued run up in commodity prices, but investment demand plays an equally important role. The current demand from investors can either go directly into specific commodities via the futures market or exchange-traded funds, or via products such as bank provided swaps or index funds that tracks one of many well known commodity indices.
Three of the best known are the Bloomberg Commodity index, which we often use given its broad exposure across the three sectors of energy, metals and agriculture, and the S&P GSCI as well as the DBIQ Optimum yield diversified commodity index.
The composition of the three is shown below and it helps to explain why energy and in particular crude oil benefit greatly from increased investment demand. For each dollar an investor puts into an index tracking ETF or swap note, somewhere between 30 and 60 cents is being invested into energy products from crude oil and fuel to natural gas. Drilling a bit deeper we find that between 15 and 30 cents of each dollar invested goes toward an exposure in Brent and WTI crude oil.
Brent and WTI crude oil trade higher for a third day with Brent getting tantalizing close to $70/b, a level it briefly breached two months ago before suffering a 15% correction. The market, already supported by investment demand has also increasingly been focusing on reopening’s in Europe and the U.S. offsetting concerns about weaker demand in parts of virus-hit Asia. Especially in India where analysts forecast a sizeable drop in fuel demand this month between 0.5 and 1 million barrels/day.
Yesterday the market received an additional boost after the American Petroleum Institute reported a steep drop in U.S. crude stocks as well as sizable drops in both gasoline and distillate (table below), thereby reinforcing bullish views on fuel demand in the world’s largest economy. As per usual I will publish the result of the report on my Twitter profile @ole_s_hansen once it has been published at 14:30 GMT.
Comment from our technical analyst Kim Cramer Larsson:
Since late March Brent crude oil has traded in a narrow four dollar rising channel, currently between $66 and $70. RSI is bullish with no divergence which indicates a likely test higher towards the next level of interest at $71.30/40, the March top and trendline connecting the previous three peaks. A break above could see the contract target the 2019 high at $75.60
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