Juggling Dynamite

As we explained in our month-end client letter yesterday, net speculative longs in commodities closed March at an all-time high. That’s a whole lot of highly levered speculators betting that commodity prices will keep rising.  Maybe, but never indefinitely.  The quadrillion dollar question, of course, is where’s the top.

Making up 31% of the London Metals Exchange Index (LME), copper prices rose 108% from March 25, 2020, to $4.335/lb on February 24, 2021.  This is very close to the price peak in the 2008/2011 commodity cycle.  Since February, copper prices have retraced about 8%.

As shown here courtesy of the DailyShot, extrapolating the uptrend, speculators started April, the most net long copper since the cycle peak in 2011.  A lot of inflation expectations are baked into this picture.
Those inflation expectations caused government bond prices to sell off just over 4% in the first quarter of 2021–the biggest decline since 1980, as shown below—this is what stock Permabulls like to call bond ‘carnage.’
With the junkiest bonds now priced like cash-good deposits collecting record-low yields under 4%, speculative fever is in full bloom, and the safest treasury bonds may indeed retrace further in the weeks ahead.  But here’s the thing:  each move lower in 5 to 30-year treasury prices inversely increases the borrowing costs for debtors who owe more today than at any other time in world history.

If most had borrowed that money to increase their free cash flow and thus help repay the loans, that would be one thing.  But this has not been the trend.  Quite the opposite, in many countries households have borrowed record debt to finance the most expensive housing in generations. While public corporations have borrowed to buyback shares, increase dividends and merge.  In the process, the fixed capital investment (that can improve efficiency and productivity) has plunged to the lowest level in at least 25 years.

The chart below shows Canada’s pattern, with residential ‘investment’ in red since 1960 compared with fixed capital investment ex dwellings as a percentage of GDP in navy.
We note that these two trends have been negatively correlated and reliably mean-reverting for decades.  A reversal is overdue and much needed, especially if we hope to pay down the debt now accumulated.
Historically, debt booms and speculative frenzies have been inflationary while expanding and then deflationary for years thereafter.  It’s hard to see why this one should be different.

After peaking a year ago at just over $102, the US dollar against a basket of global currencies sank to $89.20 in early January as the consensus predicted further dollar weakness and commodity strength.  Something else happened.  The dollar index has strengthened, while the CRB Index–a basket of 19 commodities (39% allocated to energy contracts, 41% to agriculture, 7% to precious metals, and 13% to industrial metals)– has lost its earlier momentum.

As shown in my partner Cory Venable’s chart of the CRB Index (below since 2006), a speculative financial frenzy drove commodities up 64% from October 2006 to June 2008 (left green band) before prices and interest rates relapsed with the economy into an extended recession and bear market (pink band).

The long-established reality about high prices is that they encourage supply more than demand, and therein lies the seeds of their demise.

Time will tell if the commodity price top is in for this cycle or if further price pressure follows in the months ahead.  But with the CRB having already risen 94% between March and January 31, 2021, some robust demand hopes and infrastructure plans have surely been priced in.

The segment below offers a good (and dramatically articulated) market summary as we end Q1 2021.

This week Real Vision’s Roger Hirst uses Refinitiv’s best-in-class data to look at the cracks that have been appearing across the financial landscape after only a small bounce in the US dollar. Many of these issues will be dismissed as one-off events, unconnected by geography or asset. But they could all stem from cheap and abundant dollar liquidity that is showing increasing signs of sensitivity to a small reversal in the fortunes of the dollar. Turkey and Brazil have recently shown their vulnerabilities and the problems of leverage within a family office all represent risks that are lurking under the bonnet.

Here is a direct video link.

Longer-term government bonds are selling off, and their yields are rising, as commodity speculation and inflation expectations have leapt over the past seven months.  Central banks are throwing everything they have to maintain asset inflation because they cannot inflate wages, the necessary catalyst for sustained price inflation.  At the same time, leaping yields and commodities are the undoings of an ever-more indebted economy with non-replacement birth rates.  Therein perpetuates the deflationary circle that persists.

A. Gary Shilling’s latest Insight for April (behind paywall) is a deep dive into the underpinnings of inflation and deflation. For non-subscribers, some key points are summarized in the article 4 Reasons Wall Street Is Wrong on Inflation:

• Americans will continue to save their stimulus money and pay down debt.
• Wages are not rising sharply, and increasing commodity prices are temporary.
• The increase in Treasury debt will be absorbed by investors and offset by an increase in consumer savings.

Also, see Ed Yardeni’s paper Four deflationary forces keeping a lid on inflation.

Higher yields are worse for debtors but better for savers as maturing cash can roll into higher-yielding deposits that rise in price when risky assets enter their next well-earned nervous breakdown.  Treasury bonds and cash preserve capital and liquidity for equity buying once highly levered markets are once more liquidating:

Shilling recommends that investors hold long-term Treasury debt. He also recommends shorting tech stocks and heavy holdings of cash.

Asked about what he’s waiting for to put his large cash allocation to work, Shilling said he’s “waiting to see if we get a blowup in the stock market.”

That could happen again to stocks that are attracting heavy speculative buying, like special-purpose acquisition companies and like GameStop and AMC did in late January. Those two stocks have since fallen sharply from their highs, though they remain well above their prices at the start of the year.

Shilling sees “inflation in those kinds of areas, not in spending for goods and services, which is a good reason there could be a major bear market in stocks.”