Wednesday, September 24, 2014

How commodity traders are making ONE BIG BET

A number of years ago, I worked as an equity portfolio manager at a Commodity Trading Advisor that used trend following models. While I knew nothing about the specifics of their models, I knew that the traders next door appeared white-knuckled at the end of the day. Even though they were diversified across many different contracts, the trading system often steered them into a single BIG MACRO BET. The bet might be characterized as a directional exposure to interest rates, or currencies, etc.

It was then I realized that the application of trend following models on commodity, bond and currencies was picking up directional economic trends - but that's another story.

I was reminded of that story when I was watching a technical analyst being interviewed on one of the financial TV networks and he was going through commodity charts, one by one. Here is the outlook for copper, oil, gold, etc.

I wanted to shout, "No, no, no! Just watch the US Dollar!"

USD breakout = Commodity weakness
In my recent post Overbought USD = Commodities poised to rally?, I wrote that the USD Index was highly overbought and coming up against major technical resistance. I postulated that the greenback was poised for a reversal and, as a result of its negative correlation to commodities, commodity prices were about to rally.

It seems that I was wrong, at least on the short-term reversal. As the chart below shows, the USD has staged an upside breakout from resistance.

As commodities are inversely correlated with the USD, commodity sensitive markets and sectors have struggled recently. To filter out the squiggles, I show the point and figure chart for selected markets. Here is the South African market, which has violated a key uptrend:

The Canadian market, as represented by the TSX Composite, also saw an uptrend violation (in purple), though longer term uptrends (in green and blue) remain intact:

The Australian market is holding up ok for now as an uptrend remains intact:

A glance at the relative performance of the Energy sector to the SP 500 reveals its lackluster relative performance. Energy stocks have been in a relative uptrend in the context of a longer term sideways trading range.

The relative performance of Metals and Mining against the SPX can only be described as "sick":

What now?
So what now? In light of a USD upside breakout, should commodity bulls throw in the towel and eat their losses?

A look at the longer term 20-year USD chart shows several past episodes where the USD Index had reached similar overbought conditions. They all saw pullback soon thereafter. Some (marked in blue) saw further advances after the overbought condition was alleviated.

The key issue is whether traders should buy or fade the anticipated strength in commodities.

Here are a couple of questions to be considered:

  1. What is the near-term outlook for China, which is the biggest marginal consumer of commodities?
  2. What is the likely outlook for the USD?
The AUDCAD currency cross gives us some clue about what Mr. Market thinks about China. Both the Australian and Canadian economies are commodity producers, but Australia trades more with China and Canada trades more with the US. The chart below shows the AUDCAD cross has violated a key technical support zone and it is in a downtrend. It does, however, appear to be trying to consolidate near a Fibonacci retracement level.

While the AUDCAD cross appears to be telling a China-bearish story, a WSJ story that PBoC Governor Zhou Xiaochuan may be short-term China bullish. While Zhou has led many PBoC financial reforms, such as ending the USD peg and liberalized interest rate policy, which has started to end financial repression of the household sector, he has stood firm against wholesale stimulus efforts when the economy starts to slow, as it is doing now. It is rumored that President Xi would prefer the PBoC to be more accommodative during such periods and Zhou's replacement is more likely to induce more credit-driven growth during current periods of subpar growth - and that would be commodity demand friendly in the short-term.

As for the second question about the likely outlook for the USD, Mr. Market considers the US a major locomotive of growth today. Consider this chart of the relative performance of the SPX relative to the MSCI All-Country World Index. The SPX recently staged a relative upside breakout in the context of a long-term relative uptrend.

As well, the US 10-year yield is roughly 2.6%, compared to 1.0% for the Bund, both of them considered to be the "risk-free rates" for global investors. Though the growth and monetary policy outlooks are very different for the two regions, The 1,6% differential is likely to attract funds to the USD and exert downward pressure on the EURUSD exchange rate.

In conclusion, while the USD appears overbought and commodity prices oversold, my inner trader is positioning himself for the inevitable commodity rally, but my inner investor is positioning himself to fade the coming commodity strength as he is a longer term USD bull.

Even if you have no currency or commodity positions, you should pay attention to how this USD/commodity trade develops. Rising commodity prices affect inflationary expectations, which feeds into the timing of Fed policy changes.

Stay tuned.


TraderO7 said...

Excellent comment my Humble Student...err...Professor of the Market...your 'free' excellent comment exceeded far more than those from those paid services...

Anonymous said...

Outstanding post and greatly appreciated indeed! :-) Really provides a great insight into "deeper" factors driving the Dollar.

Anonymous said...

Thanks again your posts are always helpful.

Mac said...

What a great article. I consider myself a beginner so I had to read it twice. It was even better the second time around.

Unknown said...

This is good for all traders and reliable for new investors. In time gold market has very fluctuated compare to silver. It fully depends on the economic condition of the market and its movements.!!!!!!!!!
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