The change in commodity margin requirement has finally had some impact on the market. Clearly this was the main driver behind Thursday's selloff in commodities, but more importantly, the growth slow down we keep banging on about has reached new lows.
First to the main cause of the timing of the selloff. On 4 May, Wednesday, the CME said that from 9 May the the minimum amount of cash that must be deposited when borrowing from brokers to trade silver futures will rise to $21,600 per contract. That was up from $11,745 two weeks ago. Last week, the futures price jumped to a 31-year high of $49.845 an ounce.
Below is a simplistic model for a risk-on versus score on fundamentals. It’s AUD/JPY (the ultimate risk-on indicator), Copper (the lead world growth indicator) and finally Citigroup's Surprise Index on economic data, measuring whether data is better or worse than expected. The red line has for a long time been warning us that something was wrong with risk-on – it has fallen into negative territory that we have not seen since the low in the stock market. But policymakers will NOT allow the market to go to low in this cycle.
Source: Bloomberg, Saxo Bank
Our preferred scenario of QE3 introduction in Q4 2011 has gotten closer. Yes, there are political issues in getting it in place, but with the uncertainty in the EU (Portugal + Finland), there is plenty motivation for politicians to unite with central banks once again to secure what I have coined the 'QE to Infinity Scenario', scenario 2 in our simple representation of our three main scenarios below.
Source: Saxo Bank
I have called for 1385/1400 in the S&P (cash) index since coming back to Saxo Bank. The high in this cycle has been 1370.58, which means I must revisit my forecast and correct according to this.
The highest probability scenario is QE Infinite, which I give a 60% likelihood. This is a scenario where central banks and policymakers will not allow corrections to exceed 10-15% before “new measures” are introduced to secure future growth. But the traction achieved with QE will be less and less, hence the slightly lower highs in the stock market. Ultimately this scenario leads to a bigger correction but the timing could be 2013- to 2015 before it happens. (Compounding the negative policy errors.)
The second most likely scenario being a 1970s repeat, on which I place a 25% probability. Here, the S&P moves sideways for an extended period. Making small nominal gains quarter on quarter. This scenario is not necessarily negative-negative, as it will be under stagflation conditions: high inflation, low growth, which will force the economic agents to change and act more efficiently.
The least likely, but best for world economy is deleveraging/Crisis 2.0. Odds of 15%. In this scenario we will have one more go for QE – but it will fail as we move into Crisis 2.0 – this will lead to massive deleveraging and create the political opportunity for change as we are in such a crisis that things need to be done. The 'forest fire' of financial markets. It also happens to be the most positive scenario long-term as we could follow this necessary correction with multi decades of growth and stock market gains, as the crisis would have recycled capital, created better leverage, a better ratio of capital to debt in any investment and forced a change towards alternative energy. This scenario's main premise being: 'Crisis is good, it’s the only way we can change the political environment.'
Strategy implications
Commodities have seen a serious correction, but remember this is the norm.
CRB Index since May 2009 with correction in circles.
Source: Bloomberg, Saxo Bank
From a top-down allocation point of view I remain constructive on commodities, bearish fixed income and I still think 1385/1400 could happen in S&P. QE Infinite will become a play very soon as the market has now corrected (rightly) growth expectations to a new low.
The US dollar remains at risk – although this correction was good for positioning and deleveraging risk in Silver/Gold.
The risk of Fed changing their low-rates forever strategy remain muted - and so does the prospect of getting natural correction/deleveraging beyond the odd 10-15%.