Commodity futures extending the losing streak

Commodity futures, represented by crude oil, have been extending the losing streak since mid-Jun. In the meantime, US dollar index has been rising, and even US treasury bond yield has rebounded continuously, reflecting notable features of risk-aversion.

It is not surprising that commodity futures decline due to its volatility, but still the recent month-long losing streak is unpredictable as it has lasted for such a long period with no solid rebound. Then, what’s the cause behind it?

The super strong interest rate hike expectation, followed by concerns about economic downturn, appears to be driving force to decline in commodity futures.

1. Largest interest rate hike in 28 years

On Jun 10, US released economic data for May, that the CPI surged 8.6% from a year ago, beating the forecast of 8.2% and exceeding Apr’s 8.2%, indicating the inflation remains elevated. As a result, US stocks tumbled that night.

Due to the higher-than-expected inflation. Market expectation for Fed’s Jun interest rate hiked was adjusted from 50 basis points to 75 basis points. On Jun 15, Fed announced to raise interest rate by 75 basis points. Though Fed governor Powell said interest rate hike of 75 basis points would not be a normal state to quell the panic, the hike had dealt a severe blow to stocks market as well as commodity futures.

On the day after the hike, besides that refined oil product to crude oil price spread reached a plateau, energy, chemicals, metals, precious metals, agricultural products all got impacted.

The higher-than-expected CPI in May leads to the burst of illusion, and it is realized that only by taking tough measures can the rising inflation be stemmed.

That is to say, now that the supply issue can not be resolved, the interest rate should be raised to curb the demand. To put it bluntly, the high inflation can only be reined in by economic recession. For Fed, it is a choice between recession and inflation.

2. Knock-on effect

With the easing policy tendency receding, the weakest link would be the first to get impacted. After US, as the strongest economy, began bigger-than-expected interest rate hike, the impact would be more manifested by its knock-on effect.

Consequently, investors were short selling in stocks, bond and exchange rate markets in Japan and Europe, and Japan government bond futures collapsed. US dollar to Japanese yen exchange rate rose to break 135 and reach 139. The difference between the yield on the 10-year benchmark Germany government bond and its Italian equivalent widened to 2.4 percentage points. Italian Prime Minister Mario Draghi said on Jul 12 that he would resign, which also raised concerns about crisis in Europe.

The strengthening of US dollar came as a result of interest rate hiked, and also the worse situation in Europe and Japan. Since of outbreak of Russia-Ukraine conflict, Europe has been mired in energy crisis, with inflation soaring. On Jul 11, Russia announced to shut Nord Stream 1 natural gas pipeline for 10 days. The market concerned that the pipeline may not reopen and the panic exacerbated. Afterwards, euro fell to parity with US dollar.

US announced on Jul 13 that its Jun CPI beat expectation to 9.1%, and the market expected Fed to raise interest rate by 100 basis points in Jul, which triggered another round of market slump.

3. Risk of recession

The expectation of recession trade does not come out of nowhere, but is looming. Even for US, the strongest economy, its economic data are slipping heavily. After inflation adjustment, US May consumer spending was down by 0.4% on month, the first drop in 2022. May after-tax income dropped by 0.1%, indicating income growth lagged behind price rise. Apr US personal savings rate declined to new low in more than a decade, indicating savings are being consumed.

Besides from US, global economy is at risk. It can be seen that US and European economic data are weakening, while other countries could be in a more dire situation.

However, this round of market slump may still be sentiment-driven and short-lived. Supply shortage may not be relieved in the short term, and energy remains strong. On supply side, rise of US crude production is slow, OPEC’s spare capacity is limited, Russian production is unlikely to return, and Iranian nuclear sanction is stepped up, thus, there’s no concrete solution yet. As for demand, there’s uncertainty when it will shrink and how much it would decline. Therefore, the market may keep fluctuating, and the inflation and fluctuation would pose continuous challenge to the market.