Although USD had declined when macro-economic data came out more strongly than expected in recent months, the opposite happened Friday. The dollar index surged to as high as 79.07 before closing at 78.06, +1.2%. Over the week, the gauge added +0.8%.
The phenomenon suggested the market has begun to factor in faster rate hike or at least the Fed will deliver a less dovish tone on monetary policy at the FOMC meeting next week.
Commodities pared gains with the energy complex leading the decline Friday, although stocks surged in tandem with USD. This suggests that the negative correlation between USD and commodities is probably more pronounced than the positive correlation between stock markets and commodities. Reuters/Jefferies CRB Index slid -0.2% Friday but gained +2.7% last week.
Crude Oil
Crude oil price retreated after surging to 5-week high at 72.84 as USD strengthened Friday. The benchmark contract for the black gold declined -1.4% to 70.93. On weekly basis, the gauge gained +2.1%. Others in the energy complex also plummeted Friday with gasoline sliding -2.6% to 2.01, the lowest settlement since July 30 and heating oil losing -1.3% to 1.91.
Since 4Q08, we have seen increasing positive correlation between oil price and S&P 500 Index. The correlation has soared to almost 0.8 in May. While most of us have begun to take this for granted, Friday's divergent performance in stocks and oil showed that the positive correlation is not always true.
The chart below showed that the correlation between returns on S&P 500 and WTI crude was not significant in 2007 and early 2008 but turned prominently negative in mid-2008. The inverse correlation indeed makes sense. Energy stocks make up less than 20% of S&P 500 Index. Rally in oil price can only boost up the index slightly. However, the rest of the constituents in the index may have been seriously hurt by rise in oil price, especially the industrial, airline, etc.
We believe the in-tandem movement between oil and stocks was driven by robust confidence in macro-economic outlook. Investors saw improvements in economic data and believe between outlook would support fundamentals in energy market.
Further gauge on the correlation is required. If the divergence persists, this may indicate oil or commodity investors have shifted from trading based on macro-economic outlook to trading based on energy-specific fundamentals which remains weak and does not support recent relatively-high oil price.
The inventory report by US Energy Department sent us a mixed picture in the energy market. Crude oil inventory rose for the second week due to decline in refinery runs. We believe crude build will continue in coming weeks as weak demand in oil products and the start of maintenance season will keep refinery low.
Surprise was seen in reduction in distillate inventory, the first decline since April. However, the draw was driven by decrease in production and imports, rather than increase in demand. We believe a more sustainable inventory draw is needed to be accompanied by impressive rise in demand which we anticipate will occur in 3Q/4Q 09.
Spread between WTI and Brent crude oil has turned negative again since early July. We believe the situation should persist for sometimes time as Cushing stock, the delivery point of WTI crude, has been building rapidly. However, the situation may be soothed as production in North Sea resumes in September. This will alleviate the tightness in supply of Brent crude.
Natural Gas
Despite better-than-expected employment data, natural gas followed the broad-based decline in the energy complex and slid -1.8% to 3.67 Friday. Over the week, the gauge climbed +0.5% higher.
Although gas price rallied earlier last week, huge gain in storage damped investors' hope that gas fundamentals would improve with the help of macroeconomic outlook. The US Energy Department reported that gas supplies rose 66 bcf to 3089 bcf in the week ended July 31. This was higher than market expectation of a +61 bcf increase and has brought the increase +19% higher than 5-year average.
Usually, good job data can boost gas price but that's not case this time. In June, the US Labor Department reported that factory payroll dropped -52K, after a -131K decline a month ago. This should have been good news for gas price as industrial users contribute about 30% of gas demand in the US.
However, gas price was not helped by the job data. This is another indication that investors have now turned to trade based on industry fundamentals rather than macro outlook.
The number of gas rigs increased for the 3rd consecutive week to 681 in the week ended August 7 from 677 in the prior week. In total, oil and gas rigs in the US rose to 966 units, the highest level since April 17. As we mentioned last week, the situation that the gas market facing is a vicious cycle: reduction in supply will boost price to a level that trigger production which in turn drag down price again. We believe this knot can only be untied by recovery in demand.
Precious Metals
Gold was the only one the precious metal complex that retreated Friday. The yellow metal dropped -0.4% to 959.5 as USD rebounded. Over the week, the benchmark contract added +0.4%. Gold price has been consolidating within the range of 865 and 1007.7 for almost a year. In recent months, the trading range has narrowed to 900 and 990. We believe the main reasons for the dull situation are capitals outflows for gold ETFs and futures, as well as the rather consolidative mode in USD.
Both ECB and BOE left policy rates unchanged at 1% and 0.5%, respectively. This is positive for gold as the yellow metal usually performs well in low-rate environment. Moreover, the BOE announced to extend the asset purchase program to 175B pound from 125B pound as economic condition in the UK is worse than anticipated. Extension of QE measures increases the risk of inflation and will theoretically drive demand for gold.
Moreover, signatory of new 5-year Central Bank Gold Agreement (CBGA III) set limits on central bank gold sales. The new agreement reduces the limit of maximum gold sales to 400 metric tons a year, from 500 metric tons CBGA II. Although IMF did not sign the agreement, it's believed that the lender's sales of gold will also follow the rules inside. This should remove the overhang of IMF's gold sales.
Silver price gained +0.2% to close at 14.67 Friday. On weekly basis, the contract jumped +5.2%, outperforming gold. We expect the gold/silver to decline further as industrial demand for silver should hold up well as economy recovers.
PGMs rallied on better-than-expected US vehicle sales. Platinum price settled at 1268.5, gaining +0.4% Friday and +4.5% over the week. Palladium rose +2.9% Friday and +5.6% over the week to close at 279.05. US vehicle sales increased to an annual rate of 11.24M units in July from 9.7M units in the prior month. The reading also came in higher than consensus of 10.2M unit.
Base Metals
Base metals pulled back on early Friday after the China government announced decline in loan growth. People's Bank of China said that the government will fine-tune the monetary policy and the surge in loan in the first half was due to the government's stimulus. The pace of growth will not be as rapid in the second half. Traders took profits as they anticipated fewer projects rolling out in China means reduction in demand for base metals.
However, better-than-expected US non-farm payrolls boosted price again. Base metal complex gained Friday with LME copper, lead and zinc rising +2.1%, +2.4% and +2.7% respectively. Over the week, copper for 3-month delivery jumped +7.5% to 6150.
Although the base metal complex has become the best performing sector so far in 2009, we remain doubtful whether the rally is sustainable. The Chinese Customs will report preliminary trade data for July on August 11 and we believe a drop in net import should trigger selloff in copper and other base metal prices.
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