Fed normalisation to cap any potential upside

Over the past month, the market has endured a plethora of potential risk events, such as the French and UK elections, the ongoing political gyrations in the US and the Greek debt decision.

As we expected, most outcomes have been followed by a strong reaction from the markets. Adding to this is the increasingly hawkish undertones from central bankers in the developed world. The European Central Bank (ECB) subtly hinted at policy normalisation while the US Federal Reserve (Fed) has published a more positive economic outlook for the US while giving details on its policy normalisation procedure, likely to begin in December this year.

We believe that the ECB will begin to discuss policy normalisation while the Fed plans to increase interest rates more aggressively, and see the beginning of policy normalisation as a form of rate hike akin to 25 basis points.

The US dollar is likely to trade close to its floor, after considerable weakness this year. Positive sentiment has cooled while sentiment towards the Euro looks close to a peak. Disappointing economic data from the US suggest the upside potential for the US dollar is limited. This suggests that gold has reached its near-term peak as it moves inversely with the US dollar. Although US Treasury yields are likely to rise as the US Federal Reserve normalises rates, the pace of normalisation will be slow and thus inflation will not decline rapidly. The very gradual increase in real interest rates will mean that there will be limited downside to gold prices.More broadly across commodities we continue to see improving leading economic data from emerging markets, including China where our growth proxy measure suggests growth has continued to improve over the last few months with encouraging freight volumes and retail sales figures. We continue to see recent commodities falls as an opportunity, particularly in industrial metals.

• Warm and dry weather degrades production of grains. Within the agricultural complex there were sharp price movements in lean hogs, wheat, cotton and sugar. There appears to be seasonal factors behind the strong demand for lean hogs and live cattle. The depreciation in the Brazilian Real pushed sugar and coffee prices lower.
• Copper bucked the trend of declining prices in the industrial metal space. With speculative positioning recovering from a shake-out earlier this year, it appears that investors are focusing once again on the likely supply deficit for this year.
• Excess supply to continue to weigh on prices. How to absorb the excess supply in each individual market is the key question. Tension in the Middle-East countries may provide a boost to US natural gas exports. Meanwhile uncertainty about the real impact of the OPEC/non-OPEC production cut, growing US oil production and inventories continue to weigh on oil prices.
• Speculators in charge as palladium leads precious metals sector higher. The precious metals sector was the only one in the commodity market to experience gains across the board over the past month. Palladium remains the leader in the sector despite some softness in the auto sector, while lingering uncertainty has kept the price of gold supported despite the US Federal Reserve hiking rates last week.

James Butterfill – Executive Director, Head of Research & Investment Strategy – ETF Securities