UBS on the commods crash – and getting ready for the next one | FT Alphaville

UBS on the commods crash – and getting ready for the next one

We’ve heard from Deutsche Bank, who blamed the coming end of QE for last week’s precipitous price moves.

UBS have now added their view to the causes of the commodities crash. In a nutshell, they’re citing: “extreme positioning short the dollar and long commodities” coupled with some disappointing indicators of global growth.

Here’s the detail, from analysts Julien Garran, Tom Price and Angus Staines:

Q. What caused the sell-off?

A. We believe it was slowing growth, the hawkish tone of China officials and severely crowded positioning that caused the sell-off.

After the flood of liquidity of QE2 … we now see a difficult period for commodities and mining shares as liquidity dries up. In ‘After midnight’ April 11 2010, we highlighted four key concerns on commodity markets and mining shares.

1. Global growth was slowing faster than most expected.
2. The Chinese authorities would stay tighter for longer than the market wished or was anticipating.
3. The end of QE2 would lead to a reflow of capital to the US, a dollar bounce and risk off. Extreme positioning would exacerbate the move.
4. MENA tensions would persist – leaving a large risk premium in the oil price.

The charts [here] show that growth disappointments accelerated since the report. Macro surprises have rolled over. A key point is that high oil prices and bond yields in recent months have pinched the consumer, hitting sales and causing an involuntary inventory build. This is set to lead to falling industrial orders and destocking along the industrial and commodities supply chains. The inventory build is visible in the chart above. And our favoured leading indicator for the US – ISM new orders less inventories deteriorated.

But if you’re wondering what happened to those QEnding worries — they’re still there.

And UBS reckons they’ll really be the cause of the next commodities leg-down:

Q. What will drive the next leg down in commodities?

A. In our view a chunk of the growth slowdown, and the change in sentiment on China’s policy stance are in the price. But we think that the drivers of the next leg down; the impact of the end of QE2 on global capital flows, the dollar and risk attraction in commodities are not.

The dynamics are almost exactly the opposite to those in play as the US embarked on QE2 in Q4 2010. The Fed’s view, and our view in the UBS mining team is that QE2 operates through portfolio choices. When the Fed buys treasuries, it lowers yields relative to other risk assets – forcing portfolios to shift up the risk curve. That shift incorporates strong capital flows overseas – which can be seen in the dramatic rise in foreign exchange reserves in recent months.

Emerging market authorities tend to print domestic currency to buy dollars, to prevent excessive currency appreciation. This then raises deposits at banks, inducing a lending boom, which in turn is very commodities intense – bullish for commodities, with knock on effects on commodity currencies and speculative flows …

When the Fed ends QE, treasury yields rise relative to other risk assets – making them more attractive, and forcing portfolio shifts back down the risk curve. That induces capital to flow back to the US – directly boosting the dollar. It forces emerging market central banks to retire domestic currency as the dollars exit, leading to stalling bank deposit growth and stalling loan growth. And this in turn triggers a reversal of speculative flows. It also tends to precipitate credit stress among weak credits – who, like in a game of musical chairs, are left standing when cheap credit runs out.

Our bear market rule of thumb is that a nine month self-reinforcing cycle up (August 2010- April 2011) will take about three months of a self-reinforcing cycle down to unwind (May-August 2011). This pushes our tactical macro asset allocation clock down from zone one (Long commodities and emerging markets, short the dollar and bonds) into zone two (Long the dollar and bonds, short commodities and emerging markets).

And look, there are even some handy diagrams:

Now just imagine those arrows in reverse, commods traders.

Related links:
The deflation risk is still out there, SocGen says – FT Alphaville
The financing pyramid and margin debt – FT Alphaville
Deutsche chimes in on the commodities rout — it’s the QEnding – FT Alphaville