Commodity Bull Market on a Knife Edge

Oil and Power Industry

After having its best run in months last week, the Aussie market is set to start this week on the back foot, thanks to a retreating US stock market on Friday.

The S&P 500 finished down 0.57%, while the Dow fell 0.71%. Oil was the biggest loser, with Brent crude down 3.7%, thanks to a disagreement over output quotas between Saudi Arabia and Iran. As the Wall Street Journal reported:

Saudi Arabian and Iranian oil officials have clashed this week over production limits, people familiar with the matter said, as OPEC struggles to iron out differences ahead of a meeting next week in Algeria where output controls will be discussed.

The disagreements highlight the chasm that still separates the two geopolitical rivals on economic issues as they stand on opposite sides of the civil war in Syria and the violent conflict in Yemen.

Yes, these two countries are major rivals. Why would anyone assume that they would agree to curb production together? The market had either priced in some sort of OPEC agreement, or it was just a convenient excuse for the heavy selling on Friday.

While the oil selloff was a sharp one, there’s no need to be too concerned just yet. The important level for oil bulls is just under US$42 a barrel, as marked in the chart below. That’s the early August low, and if Brent can hold above these levels and then move higher, it increases the probability that the final low for oil occurred at the start of the year.

Source: Optuma
[Click to enlarge]

If, however, the August low gives way in the coming weeks, it will confirm that oil is in a bear market, and it would increase the likelihood of prices falling back to the lows of January 2016.

That’s also a risk for the broader commodities sector. The chart below shows the Thompson/Reuters CRB Commodities Index. Since bottoming at the start of the year, the index rallied into June and is now going through a corrective period.

Source: Optuma
[Click to enlarge]

As long as the index remains above the green line, the odds are in favour of the young commodities bull market continuing. But a break below there would bring the bear back into play. Given oil’s dominant effect on this index, much depends on its performance in the weeks ahead.

The fact that an interest rate rise seems likely in the US soon will weigh against the commodities sector. But if higher rates come with an increase in economic activity, commodities will benefit.

The market will tell you which way things are going before the headlines do, so keep an eye on the support levels above.

Another potentially bearish development for commodities comes from a recent decision by the Federal Reserve, as reported by the Financial Times:

Banks will have to carry billions of dollars in extra capital if they trade hazardous materials such as oil and natural gas under a proposed US regulation meant to lessen the risks of liability from spills, explosions and other catastrophes.

The Federal Reserve on Friday released a proposed rule governing Wall Street’s involvement in physical commodities that would stiffen capital requirements, tighten limits on trading activity, remove banks from the business of running power plants and restrict their activities in the copper market. Banks that stay in the market despite the restrictions would have to reveal their commodities holdings to the public.

It’s hilarious what regulators will do to try and lessen the risks to financial stability. It’s not as if years of easy money and quantitative easing created so much liquidity that ALL assets benefited from increased activity.

And it’s not as if all of this liquidity flowed through the banking system, encouraging banks to get involved in areas that they wouldn’t normally be associated with.

This is just another example of the Fed trying to put out a fire it started years ago. It really is comical.

But it’s not about to end. This week, we get another barrage of Fed speakers ready to manipulate the market to their own particular whim. Notably, Janet Yellen and Vice Chairman Stanley Fischer have speeches lined up.

Following the market’s disrespectful response to their flimsy commitment to raise interest rates last week, it will be interesting to see whether they try and talk a little tougher.

But their words seem increasingly weak in the eyes of the market. The credibility of the institution is on the wane as they play into the market’s hands.

Ian Verrender captures this nicely in an ABC News article this morning:

Credibility is an elusive ideal; difficult to attain and deceptively easy to squander.

Janet Yellen, the head of the world’s biggest central bank, the US Federal Reserve, last week shredded what remained of hers and the organisation she chairs.

Once again, she hesitated when decisiveness was required. Once again, she capitulated to fear. Rather than face the wrath of financial markets she instead chose to bow down before them. In so doing, she has made a looming problem even worse.

The looming problem, as I see it, goes something like this: The Fed commits to a December rate hike and feels like they really need to move in December. Economic data comes in weaker than expected, but, not wanting to look weak in the eyes of the market (too late for that!), the Fed decides to move in December anyway. As a result, the wind comes out of the economy AND both the market and the Fed are left stranded, too proud to backtrack on the rate cut.

The final result is that the Fed comes out of the experience with an even lower level of credibility than what they went in with!

That’s just a guess, though. A lot can happen in the space of a few months. The more important thing is to see how the market reacts over the next few days. Last week, you saw the standard Pavlovian response to central bank stimulus. This week’s price action will tell you whether that response was indeed the correct one, or whether it was just a ‘head fake’.

For now, you have to give the bulls the benefit of the doubt. But that could all change very quickly. This week will be a crucial one.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning 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 The Daily Reckoning for free here. If you’re already a Daily Reckoning 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 Daily Reckoning emails. For more on Greg go here.

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