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WCU: Focus returns to trade war

Commodities 10 minutes to read
Ole Hansen

Head of Commodity Strategy

Summary:  Commodities were no exception to this week's rule of trade war-related risk aversion.

It took one Sunday tweet from President Trump to shatter the relative calm across global financial markets. Instead of going into a week widely expected to yield a long-awaited trade deal between the US and China, the president instead tweeted that he was preparing to lift tariffs from 10% to 25% on $200 billion worth of Chinese imports.

The decision was taken in response to an apparent backtracking by China on almost all aspects of the trade deal. Predictably, it spooked the market and risk sentiment was hit across the board, with safe-haven US bonds and the Japanese yen being two of the few markets receiving a boost. 

A record short position held in the Cboe VIX future, which tracks equity volatility as represented in the S&P 500 index, raised concerns about a major blowout like the one witnessed in February 2018. 

With negotiations still ongoing Friday despite the imposition of tariffs, the market adopted a nervous wait-and-see approach knowing full well that it was dealing with a binary outcome, the result of which could swing the market dramatically in either direction.
Major Market Performance
Like most other asset classes, commodities did not respond well to the heightened risk to global growth presented by an escalated trade war. The Bloomberg Commodity Index hit its lowest level since January following four weeks of selling. The energy sector, however, held up reasonably well with a whole host of supply disruptions and geopolitical worries offsetting the negative feedback loop from equities and demand concerns. 

Metals were mixed with gold outperforming most other metals despite stopping short of a steep safe-haven surge. Silver was among those contenders bested, with the XAUXAG ratio hitting a 25-year high above 87 ounces of silver to one ounce of gold.

The Bloomberg Agriculture Index led by grains slumped to a multi-decade low with several components such as soybeans and cotton caught up in a perfect storm of ample supply and the risk of a further reduction in demand from China. 

We have to wonder, however, if the trade deal's spoiler could prove grains' champion following the latest tweets from President Trump, who teased a massive US agricultural buy in his most recent barrage against Beijing.
Bloomberg Commodity Index
Palladium, which almost doubled in price between August and late March, lost further ground in response to weak auto sales and the trade dispute moving focus away from tight supply. 

Copper was left relatively unscathed despite concerns that failure to strike a trade deal would hurt global growth and reduce demand for key commodities such as industrial metals. This reaction probably came in response to speculation that an escalated trade war could trigger stimulus policies in the US and especially China, the world’s biggest consumer. 

Soybeans slumped to a 10-year low with the market once again being caught in the trade war crosshairs, which could see bulging supply struggling to find a home. This comes ahead of a monthly supply and demand report on May 10 that would give the US government’s first estimate of the size of the grain stockpiles left over at the end of the 2019-20 season. 

The speculative combined net-short in wheat, corn and soybeans reached a fresh record high in the week to April 30. At 539,000k futures contracts short (1 contract = 5000 bushels), the short was some 488,000 contracts higher than the seasonal five-year average.
Agricultural commodities
Source: Saxo Bank
Gold tried but to reassert its role as the go-to market in times of uncertainty, but its efforts were not an outstanding success. It barely managed to muster a positive return while struggling to break above $1,292/oz, the resistance level highlighted on the chart below. 
A perfect setup for a gold rally coming from geopolitical worries, weaker stocks and lower bond yields failed to lift the market. Part of the explanation is the weaker Chinese yuan, to which gold in the past has shown a high degree of correlation. 

Until now, paper demand has been mostly negative with total holdings in bullion-backed ETFs having seen continued reductions this year. Hedge funds, who are much more price-sensitive, chased the market during this period; in the week to April 30. gold was bought to the tune of 33k lots, making it the second-biggest week of buying this year. 

The move returned the position to a net-long and highlighted the continued struggle for direction. Failure to break above the aforementioned level at $1,292/oz would now carry the risk of recently established longs heading for the exit. Likewise, a break higher, which remains our preferred expectation, could see the market move higher towards the April high at $1,316/oz followed by $1,325/oz.
XAUUSD
Source: Saxo Bank
Trying to form  a short-term prediction for crude oil at this stage is close to impossible. Increasingly supportive supply fundamentals and geopolitical worries have been countered by trade-related weakness. But with geopolitical and supply risks continuing to build, we believe that renewed strength remains the biggest risk. 

Supportive crude oil drivers

• Tightening markets due to voluntary and not least involuntary production cuts. 
• Russia’s pipeline contamination, cutting supplies to Europe
• Iran’s threat to stop observing restrictions on uranium enrichment
• US moving aircraft carrier to Middle East on credible Iran threat
• Fighting around Tripoli raising risk to supplies from Opec’s most volatile producer

Non-supportive drivers

• Risk of failed US-China trade talks prompting a global economic slowdown
• Stock market weakness and surging VIX reducing general risk appetite
• Hedge funds caught on the wrong side should the price continue to weaken

The risk to the upside despite the current US-China standoff is also being reflected in the lack of selling appetite from funds, as can be seen in the latest update on speculative positions from the week to April 30. During that week, funds continued to buy Brent crude oil despite the weaker price action following the failed attempt to break above $75/barrel. 

Adding to this, we see tightening supply in the spreads between prompt Brent crude and deferred contract months. The front July contract has reached a $2.2/b premium or backwardation above October, the widest in almost five years. The fact that the backwardation has increased while the prompt price has been falling is sending quite a strong signal that the market is growing worried about tight supply. 

In the short term, the 50-day and 200-day moving averages, which crossed to create a technical buy signal this week, provided the support needed to stop the correction. Into next week, the market will be closely watching developments in Washington and Beijing for signs of the trade war’s direction, and with that whether some additional weakness can be seen before tight fundamentals once again take over the driving seat. 
Crude oil
Source: Saxo Bank

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