February 16, 2015

Commodities should benefit from the central banks’ race to the bottom

Commentary by Robert Balan, Senior Market Strategist

"In summary, in normal economic times, both nominal and real interest rates are positive. But in unusual times, negative nominal and real yields are not unusual. Both often reflect investors' flight to safety.”

Richard G. Anderson, Yang Liu, How Low Can You Go?,  Federal Reserve Bank of St. Louis, January 2013

Since last year, some central banks have started to introduce negative rates in response to the disinflation and the risk-off environment amid a currency war. This is encouraging savers to start hoarding cash or invest in physical assets. Gold is therefore one of the main beneficiaries of the negative rates environment. But other commodities, especially cyclical commodities, should in turn be positively affected by this environment at some point.

The European Central Bank had moved deposit rates into negative territory last year, charging banks for maintaining deposits with the ECB rather than paying the banks positive interest. The hope is that this will encourage the banks to stop hoarding money, and instead lend more to each other, to consumers, and to businesses, in turn boosting the broader economy which might help bring European inflation closer to the ECB’s 2% target. While other major central banks have not followed the ECB, smaller central banks have also started to implement negative rates. In January 2015, the Swiss National Bank slashed deposit rates to -0.7%. This was followed by the Danish central bank, which has cut deposit rates to -0.75%. The Swedish central bank also announced in February the reduction of its key rate from 0% to –0.1% and that it will begin its own bond buying program. Sweden was the sixteenth country to cut rates this year. The Swedish Riksbank said it made the move to fight deflation. However, it is more likely that the central bank wants to avoid a too rapid appreciation of the Swedish Krone which could hurt exporting industries. This indeed follows the logic of other central banks and suggests that a currency war is now in progress. The rapid appreciation of Northern peripheral currencies in Europe was indeed recently triggered by the announcement of the ECB’s QE programme, and the rates cuts are the Northern peripheral central banks’ response to this situation.

Europe is not an exception. In Asia, central banks have also entered a period of rates cut in response to the massive Japanese injection of liquidity. This is hence forcing Asian central bank to act in order to prevent a very rapid appreciation of their currency, which could be especially damaging to their export-led growth models. Since the beginning of the year, India, Pakistan, Australia and Turkey have cut rates. Rates have also been cut in Canada, Peru and Russia in January 2015, reflecting the worldwide extent of rate cuts. Negative rates in some European countries, while other central banks are cutting rates to historically low levels, are likely to have a major implication for commodities.

Low or negative rates should reduce the appeal for interest-bearing assets. Investors may hence look for alternatives such as gold or the US Dollar (cash). Furthermore, as commercial deposit rates approaches zero or turn negative, savers will likely start hoarding cash instead, or investing directly in physical assets such as precious metals. Gold and the US Dollar are therefore likely to be the biggest winners in this environment. This is why the correlation between the US Dollar and gold has become positive (see Commodities Insight Weekly, Demand for safe-haven assets remains firm amid negative yields, a positive environment for gold, February 9th, 2015).

Not only gold but also other hard assets should do well in this environment, but with a certain lag. Demand growth for commodities should gradually start to accelerate as these low or negative rates stimulate consumption. Deposit rates crashing to zero or below, and falling rates on floating-rate loans to existing borrowers should encourage households and businesses to spend instead of saving.

This economic boost is already in motion in the US. The official US Fed Funds has been close to 0%. But the Wu-Xia Shadow Federal Funds rate (the actual fed funds rate modelled by Cynthia Wu and Fan Dora Xia) has fallen to almost –3% in May 2014, ahead of and lower than other countries (see charts of the week). Thus, it is not surprising to see the US with the strongest growth among developed countries. Recent consumption indicators indeed confirm a recovery of the US economy. US pending home sales growth accelerated these past months from –10% y/y in February 2014 to +8.5% y/y in December 2014, the strongest growth since July 2013. This leading indicator suggests stronger home sales ahead. The Michigan Consumer Sentiment Index also reached  98.1 in January, the highest level since January 2004 and a significant increase from the 55.3 low made in November 2008, implying growing household’s confidence (see charts of the week). The combination of improved consumer sentiment, lower unemployment and weak oil prices have triggered stronger automobile sales, which rose by 13.6% y/y in January 2015, up significantly from last year’s average growth of 5.4%. In turn, this boosted US gasoline demand, which rose by 6.4% y/y in January 2015. US aluminium consumption between July and November 2014 (latest available data) also rose by 34% y/y on average due to a low base in 2013 and higher activity of the automobile industry as more aluminium is now used in car manufacturing (see charts of the week).

Other countries are imitating the US model of negative or extremely low rates and/or massive liquidity injections. The reaction of central banks to the disinflationary environment already has a positive impact on the demand for gold and the US Dollar. As it was the case in the US, low or negative rates will take some time to impact the global real economy. Thus, global demand for commodities could gradually accelerate in the coming months. After strong price adjustments last year, cyclical commodities should benefit from this pro-growth policy.

Commodities and Economic Highlights
Commentary by Alessandro Gelli

International oil agencies see a decline in oil production in H2 2015

Last week, several international agencies have published reports, confirming that US oil supply should decline in the second half of the year, reflecting the consensus of the likely tighter oil market at the end of this period. The OPEC Secretariat expects non-OPEC supply to grow by 850’000 b/d y/y in 2015, a downward revision of 420’000 b/d due to important capex cuts and the large reduction in US drilling counts. OPEC expects the US oil production to start declining during the second half of the year. Production from other non-OPEC countries is also expected to decline sharply during Q2 2015 (-570’000 b/d q/q) due to weaker production in Europe and in former Soviet Union.

The International Energy Agency (IEA) released its latest forecasts. It expects the global supply build-up to halt in July. The agency predicts that non-OPEC oil production will grow by 800’000 b/d y/y, significantly lower than the record growth of 1.9 million b/d y/y in 2014. Non-OPEC oil supply growth could then average 570’000 b/d y/y until 2020, which is significantly lower than the past five-years average growth of about 1.0 million b/d. The IEA revised lower US crude oil production growth for 2015 by 200’000 b/d from its report last month, with most of the cuts in the second half of 2015 due to large cuts in capital expenditures recently announced. While the weaker supply growth should be supportive to oil prices, the IEA also warned that global oil demand should grow at a slow pace, despite the fact that oil prices have fallen by more than 50% since the middle of last year. The IEA expects global economic growth to remain weak. However, the agency may underestimate the impact of low oil prices on demand. Already, signs of stronger oil demand growth are appearing in the US, where low taxes on fuels have contributed to an elevated price elasticity of oil demand. In January 2015, implied US petroleum products demand was up by 2.9% y/y, an acceleration from the growth recorded in Q4 2014 at +0.7% y/y.

The US Energy Information Administration (EIA) also projected an important build-up in oil inventory in the first half of 2015. Global oil inventory are expected to increase by 900’000 b/d on average in H1 2015. Weaker supply growth, especially in the US, due to lower oil prices should then contribute to only a slight build-up in global oil inventory during the second half of 2015. The EIA expects non-OPEC supply to grow by 800’000 b/d y/y, a similar amount to that expected by the IEA. The US agency expects global oil demand to grow by 1.0 million b/d in 2015, a forecast between the ones made by the IEA (+0.9 million b/d y/y) and the OPEC Secretariat (+1.2 million b/d y/y). The lack of consensus about demand growth contrasts with the consensual view on the decline in US crude oil production in the second half of 2015. A more rapid than expected demand growth, as suggested by recent US data, could therefore lead to a more rapid return to equilibrium than what international agencies expect.

Weaker investment and jewellery demand for gold mitigated by elevated political risks and central banks purchases

Last week, the World Gold Council released its report on gold demand trends for 2014.The report showed a decline in global demand for gold by 4% y/y to 3’924 metric tons, a five-year low. This followed the 11% y/y decline experienced in 2013. The decline in gold demand was driven by lower demand for gold bar and coins. Demand for the latter fell by 40% y/y to 1’064 metric tons, the lowest level since 2009. Disinflation pressure, a stronger US Dollar and the relative good performance of the US economy contributed to reduce investment demand for gold. Demand from ETFs and other investment vehicles also declined by 159 metric tons. ETF holdings of gold at the end of 2014 fell to 53.9 million ounces, the lowest level since 2009, and down 8% y/y.

Chinese gold demand for gold bars and coins fell by 50% y/y to 190 metric tons (-194 metric tons) in 2014 and was hence the largest contributor to the decline in global gold bars and coins demand (-702 metric tons). Lower gold demand from China contributed to bring India back as the world’s largest gold consumer — despite a decline of 14% of Indian gold demand in 2014. In 2014, jewellery demand also fell by 10% y/y to 2’153 metric tons, accounting for 55% of global gold demand last year. This followed a strong rebound in jewellery demand in 2013 (+19% y/y), which reached an elevated level as gold prices reached low levels, encouraging demand. Nonetheless, this was slightly mitigated by stronger gold purchases by central banks. According to the World Gold Council, gold demand by central banks reached 477 metric tons, up 17% y/y (+68 metric tons y/y), driven by Russia. The country purchased an additional 173 metric tons, accounting for 36% of total central bank purchase in 2014.

But gold demand for investment has started to accelerate these past few weeks. Indeed, several events have contributed to increase demand for gold as safe-haven asset: growing political uncertainty in the Eurozone, following the election of the Tsipras government and recent cuts in interest rates or liquidity injections by central banks. The stronger demand for gold was reflected by the large rise in ETF holdings of gold. The latter increased by 5% since early January 2015, the most important rise since 2012. The current uncertain political situation in Europe, and monetary easing outside the US should provide support for further investment demand for gold. The World Gold Council also expects gold demand from both India and China to rise to 900-1000 metric tons this year. This is hence a positive environment for gold.

Charts of the week: Official and Shadow US rates / Low rates and US Economic data

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