The reflation trade, consisting of pricing high growth due to normalisation of the economy after the pandemic recession, is impacting real rates the most. Large fiscal deficit created to induce economic recovery without central bank monetisation of this debt (US case only) has the direct effect of increasing long term rates. On the other hand, the market is not pricing any quick return to inflation, except on the commodity side, where prices have become much more expensive and are putting pressure on goods (service sector remains deflationary). Real inflation often lags growth and the recent sharp increase of real rates, with the 10 years US treasury reaching 1.6% is impacting markets. Expected inflation remains low from the implied TIPs bonds largely explaining the strong correction we have seen in gold in February (-7% in EUR terms, Year to date gold is down nearly 10%). With real rates having a limited upside at that stage (from historical standard), gold remains the inflation hedge of choice for the second part of the year but may see lower levels in between. Economic activity1 fueled by additional fiscal deficits is expected to continue to inflate the consumption of base metals (Copper was up 15% during the month). The market anticipation of a commodity super cycle made a strong positioning in copper towards an overcrowded trade, even if fundamentals are justified.
The willingness of the OPEC+ consortium has again surprised with their decision to keep its production quotas unchanged for April. Saudi Arabia will also extend its unilateral 1 mb/d cut targeting a normalisation of global oil inventory toward pre-crisis levels. Given the rate of change of global inventory, pre-pandemic levels are expected to be reached in June, with possibly a market still in deficit. Such a situation could send the price of Crude to levels close to 100 in the next few months. US shale supplies seem to be much more inelastic than expected and the ramp-up looks slower as the country is still facing COVID lock downs and social distancing measures. The steepening of the curve toward backwardation is an immediate and lasting effect that is a consequence from the situation. The exceptionally US cold weather meant that US shale gas production plunged for a few days which had a very strong impact on natural gas as it coincided with an increase of consumption. The short term contract jumped to nearly 3 USD/MMBtu (a price increase of 15% before going back to end the month at +6%).
The soft commodity sectors rallied strongly in February also pricing in a strong increase of demand in the next few months. The reflation trade was exacerbated in the cotton market as supply concerns in the US crop coincided with stronger import appetite from China (+8.5% in February). In the sugar market (+8.8% last month), shortage of containers and port congestion is delaying exports and squeezing the market in a tight global supply. Coffee (+10%) had strong optimism in anticipation of an increase in retail sales in the US (US retail sales jumped 5.3% in the month), and a lower than expected production in Brazil. Similarly, cocoa (+7.8%) had anticipated a recovery in chocolate sales. Lastly, expectation of the opening of the transportation industry in Q2 and Q3 in Europe and the US had a large impact on rubber price showing a jump of 15% on the month.
Despite the somewhat bumpy ride in global macro markets, February generally saw a decrease in implied volatility. The exception being the energy sector, where solid gains in crude have driven up the price for protection against a fall. Crude implied volatility is up from 35% to 41% on the month. The VIX is down from 33.09% to 27.95% and the VSTOXX is down from 29.01% to 26.86%. Equity volatility had a bit of a revival later in the month after both indices bottomed around 20% mid month. The agricultural sector saw the sharpest decline in volatility, with a sustained uptrend in underlyings. Implied volatility is down from 28% to 22% for soybean and from 37% to 28% for corn. In the precious sector, implied volatility for gold is unchanged at about 18% whereas implied volatility for silver is down from 61% to 40%, reverting January’s gain after the failure of ‘meme traders’ to squeeze the silver market’s shorts.
1 Read the latest report to our proprietary index on China’s economic activity: Commodity Leading Index Economic Activity China (February 2021)
Source: Four Elements Capital