“Wars are not won by evacuation.”

Investors waiting to be rescued by rate cuts from the Fed

Any market or trading views are purely my own thoughts and views and in no way are to be considered investment advice.

In writing this month’s newsletter, the consistent them one of hope that the war on inflation has been “won”, whilst central banks keep telegraphing they are not finished. As a consequence the key macro markets are sending conflicting signals across the different asset classes. Equity markets have shrugged off any fears of bank runs, crude oil found some life thanks to OPEC production cuts (and then gave it all back) and bonds even performed ok. Meanwhile, grain markets are signalling no supply issues in H2 2023 which should lead to lower inflation.

Equity markets in the US and in most developed markets remains well bid into the start of Q2 2023. The US seems to be benefitting from reasonable earnings from strong growth (backward looking) and yet are pricing in cuts in interest rates later in the year (which is helping growth stocks). One of these assumptions does not add up. The longer core inflation stays elevated and the equity market strong, interest rate cuts look unlikely. Outside of the US, DM’s and EM’s are benefitting from rotation flows and a weaker dollar as investors look to diversifty out of their overweight US status.

What does this mean? Equities look expensive, bonds look fairly valued on the front end and FX looks on the precipice. If the USD holds key support here around 100-102 base the DXY (about 1.10 resistance on the Euro) then we might have seen an interim high in risk assets. If the USD breaks down through this level this should give a strong leg up in equities, base & precious metals and crypto.

For the USD to weaken it would need the Fed to relax its hawkishness (which is what the market expects, but not what the Fed officials are saying) and the ECB, BOE, BOJ to get more hawkish. Whilst possible, its hard to see a scenario where the US breaks before the other major central banks. This belief has certainly driven the Euro off the below parity lows to close 1.10, which helps to reduce the cost of energy imports in EUR terms. However, a persistantly higher EUR would start to impact EU regional export competitiveness so it can be too much of a good thing.

What am I missing? Are the flows out of the US into Europe/UK enough to continue to drive Euro and the Sterling higher? This is a possibility and something not to dismiss as I do think the US equity market decade plus long outperformance. I am just not convinced this occurs in Q2 2023.

It is hard to understate the impact a weaker dollar and the expectations of a dovish Fed in H2 2023 is having on asset prices YTD performance. The only exception being Crude Oil.

We are heading towards the middle of Q2 2023, China has re-opened, air travel is rising globally and yet oil markets remain on the defensive. The supply cuts from OPEC created a sharp jump higher in prices (and spreads) but have given most of that back subsequently. Technically, the gap fill is a good thing as long as prices can hold this level and start to build support.

The flat price was on the verge of breaking down until the 28th April when it recovered to close just on the 100-day SMA on the continuous front month chart of WTI. Maybe a benefit of month end flows. The month of May will be instructive for determing the next few months of price direction.

With the crude oil market it is a race between relatively tight available stocks and the potential of supply disruptions and sluggish demand. The bulls remain stubborn (but wrong) and whilst I agree with the structural view the drawdown in price from the summer of 2022 is pretty humiliating (and hopefully humbling). From a high level, the price action post the OPEC cuts is not confidence building. So whilst taking some pain on a short spread view, I find it hard to be long crude without a more robust demand outlook.

In theory the most bullish of all commodities, continues to disappoint. I am no expert in copper but when a bull thesis is widely held, with high conviction from both consumers and producers you have to be worried. Why? Commodity markets are efficient at solving supply shortages and perceived forward production short falls. Unlike negative prices, you can’t have negative inventory so perhaps the prices of 2022 have sufficiently boosted supply and more importantly decreased demand enough for the near term.

In commodity market you have to have strong views, loosely held. (Thanks Jim). So whilst I appreciate demand thesis for copper, low visible inventories and the weak USD, prices are basically flat for the year. So is it still a bull market?

I have been concerned about the price action in these markets for some time. Corn looks to me like a market that is rolling over on a longer term basis. I have been lucky enough to come across some great research by Susan David. I strongly recommend if you want to get into the weeds of these markets. The month of April has seen calendar spreads do well across corn and soybeans - must be bullish right? Fundamentally, you like to see strong backwardation if you're bullish. But when its combination with tanking basis levels and a huge new crop supply maybe its a false signal this time. The below in italics is taken from Susan’s No Bull Substack page:

While the U.S. is still the #1 producer of corn, it's important to acknowledge that other countries have made sizable increases in production the past two decades.

Since 2000, our share of global corn production has declined from 40% down to 30% as China, Brazil and others have made notable advancements.

The largest increases of the past twenty years were in Brazil whose production is up 200% from 2003 to a record 4.9 billion bushels this year, and Ukraine, who saw an eye-watering 995% increase in production from 2000 to 2021.

If there is one thing I want you to remember today - it is this chart:

Despite this the May/July corn spread has ripped higher driven by nearby tightness in the U.S. and classic trade squeeze as sales were made to China in March 2023.

Meanwhile, December corn languishes at prices not seen since January 2022.

Soybeans have not faired much better with weakening Soybean premiums in Brazil as supplies for current crop and the expectations on new crop weight in sentiment.

Soybean July/Nov beans is starting to waiver at the recent highs, suggesting carry out levels in the US should not get any tighter thanks to the competition from Brazil exports. Whilst the new crop November contract remains under selling pressure from impending US and SAM supply expectations.

What to make of all of this?

Unless we have a supply issue in the US from unfavourable weather over the May-July growing season, prices are likely to remain under pressure. After all, soybeans in the teens and corn above $5 are not cheap prices. At the same time fertiliser and diesel prices are easing. When you combine this with the price action in crude oil, the bullish commodity thesis that everyone is so convinced of looks to be in doubt for the next quarter or two.

In terms of positioning by speculators in corn and soybeans, because both markets are still in backwardation, the passive carry strategies are all still long the front end and short the new crop months. Almost all of the speculatlive short in Corn is in new crop (from September 2023 contract and beyond).

So if these markets start drawing down further, the selling pressure could increase further in the front of the curve. If there is a supply issue in new crop, the spreads should sell off as the new crop outperforms old crop.

At the conclusion of April the uncertainty remains high across all markets. The sinking price of VIX suggests investors are bleeding on hedges in the options market and bonds prices think the inflation worry is passing.

The MOVE index in bond volatility, whilst still high on a historical basis, is well offf the highs of March 2023.

I have to agree that the cyclical forces of inflation are weakening for the time being and on a YoY basis inflation prints should start to roll-over. This should allow equity markets to remain supported but likely to remain in recent ranges. The recent weakness in Iron Ore prices as well as crude oil puts the China re-opening trade in question which could be a good thing for keeping commodity inflation from breaking out. So perhaps the war from inflation has been won? I don’t think so from a structural perspective, but cyclical pressures are certainly easing which should allow equities and bonds markets to keep bears under pressure for the time being.

Trade recommendations would be short July/December Corn calendar spreads. Close the long Iron Ore Spreads recommendation from last month (at a profit) and close short WTI spreads at a small loss. The geo-politics make it hard to hold that type of trade.

Other trades that are worth digging into are:

Commodities:

In Macro/FX: