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A Downshift in US and Chinese Growth Coupled with Risk Aversion Marks a Critical Break for Crude

A Downshift in US and Chinese Growth Coupled with Risk Aversion Marks a Critical Break for Crude

2010-07-01 23:00:00
John Kicklighter, Chief Currency Strategist
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North American Commodity Update

Commodities - Energy

A Downshift in US and Chinese Growth Coupled with Risk Aversion Marks a Critical Break for Crude

Crude Oil (LS NYMEX) - $72.75 // -$2.88 // -3.81%  

Is the global economy facing a double dip recession and a new financial crisis? That is the concern that made the capital markets swoon Thursday. A disappointing round of data for both the US and China coupled with a questionable shift in the European banking sector would have a particularly dramatic impact on crude prices for the session. Heading into the session, the benchmark NYMEX futures contract was already pressuring a meaningful support level around $75. For technical traders, this was a notable pivot and meaningful retracement level; but even the fundamental set would recognize the psychological influence this level would have and the progress towards a meaningful reversal. While the market may have already established its bias, momentum was drawn from very specific sources. As it has been these past few months, risk appetite was one of the primary catalysts for the slide. Taking stock of risk appetite across the market, European equities plunged while debt yields collapsed. Projecting a meaningful reversal all its own, the Dow Jones Industrial Average cleared the 9,800 level that has held up as a floor for equities for all of 2010. It was only fitting that crude – a speculative asset itself – would establish a critical development of its own. 

The catalyst for the decisive shift in sentiment was a complicated matter. Over the past few months, the European Union’s financial troubles have threatened to evolve into a regional crisis that in turn infects the entire globe. Today, there were mixed signals of relief and further deterioration for the region through a debt auction and the rotation of a lending facility. The euro took off Thursday on news that Spain’s auction of 3.5 billion euros worth of five-year note was fully bid despite Moody’s warning that the nation’s sovereign credit rating was coming under review. However, the 1.7 bid-to-cover ratio hardly reflected confidence. What’s more, a short-term three-month lending facility for European banks to tap in order to cover liabilities as the 12-month program (with 442 billion euros in outstanding loans) expired would draw another 112 billion euros. All told, this is not news to reassure; and the steep declines in European equities and certain government bonds confirm that.

The more salient and intelligible weight on price action would come via growth expectations. In the ever-changing balance between supply and demand, there remains a clear glut in energy and a remarkable shortfall in consumption. Today’s economic calendar gave reason to believe that energy use would further recede going forward with notable downgrades in the perceived economic health of the US and Chinese economies. Both reported significant declines in their respective manufacturing activity reports, which has a substantial impact on global demand given these two behemoths are the first and second largest consumers of oil in the world. Tomorrow’s data could further imbalance supply and demand. US nonfarm payrolls is considered a benchmark for the overall health of the economy. Already expected to report a net contraction on the month, it would take little to provoke continuation on a now existing trend.

Looking at the futures markets after the day’s remarkable developments, the active Nymex futures contract (August) showed a new record high for volume (approximately 383,000 contracts). Aggregate open interest is still exceptionally low, however, suggesting investors are not make the effort to secure entry at ‘depressed’ prices. Furthermore, the difference between the active US contract and the two year deferred widened to $6.31 – indicating a greater level of uncertainty through the medium to long term.

commodities07012010oil

Commodities - Metals

A False Sense of Security in the European Financial Sector Leads to the Biggest Drop in Gold

Spot Gold - $1,197.55 // -$44.70 // -3.60%  

Have global financial conditions materially improved today? That is what we would be led to believe given the dramatic decline from gold and subsequent stumble for the US dollar – both favored safe havens in the investment world. However, upon reviewing today’s event risk and comparing the precious metal’s performance to other asset classes; we are shown a conflicting picture. With gold on the retreat, we would expect to see traditional risk/growth-based assets climbing at an equivalent pace. In fact, we would see these other benchmarks marking the same declines with similar fervor. In fact, the Dow Jones Industrial Average cleared 9,800 to trade at fresh nine-month lows while the benchmark 10-year Treasury note yield tested lows not seen in 14 months. Clearly, there was a disconnect somewhere along the line. 

Looking over history, it is not uncommon to see divergences between speculative assets. However, when risk trends are particularly engrained and there is a catalyst that aligns investors’ interests to preserve or reallocate capital, this unifying relationship is usually at its best. Today, uncertainty would seize speculators’ attention when the financial conditions in the Euro-area deteriorated. While there may be those that say the Spanish debt auction was a success; but in reality, the 1.7 bid-to-cover was materially worse than the May auction and financing costs rose. Furthermore, the 112 billion euro demand for the six-day facility the ECB auction alongside the expiration of its 12-month, 442 billion euro program suggests there is still a considerable need for liquidity amongst European banks – exactly the opposite situation that officials are trying to confer with their attempts to boost confidence. What’s more, the downgrade in China’s manufacturing report has its own influence over investor confidence. This particular country is considered the steward for global growth and investment. Another sign that activity is slowing in this leader further undermines expectations for returns and boosts the need for an alternative.

So, what was the source of today’s remarkable selling pressure? The biggest daily decline in nearly five months has to have a fundamental source. The foundation for this for this tumble may be exclusively speculative. Trading just below a record high, this alternative to traditional assets and even fiat currency is perhaps prohibitively expensive despite its appeal safety appeal. Another possible reason for today’s sharp decline is that losses in other asset classes is forcing traders to liquidate some of their gold positions to raise margin. 

Spot Silver - $17.83 // -$0.79 // -4.24%

Silver suffered its biggest daily loss in months, and in doing so, easily cleared the congestion that has held the metal in place for weeks. Follow through is now the critical component for trend. Delayed volume and open interest data could support such a move; but only time will tell. Tomorrow’s NFPs report could generate follow through with an outcome that falls in line with the prevailing risk aversion move.

commodities07012010gold

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Written by John Kicklighter, Strategist
Questions or Comments about this article? Send them to jkicklighter@dailyfx.com

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