Why markets were caught short by the commodities sell-off

The severity of the sell-off in commodities suggests that markets vastly underestimated the impact of the unwinding of carry trades alongside spluttering growth in China and weakness elsewhere.

The plunge in oil prices and the highly-correlated declines in other commodity prices probably should have been anticipated by the markets, in which case the pace of the declines would have been more measured.

The sell-off should have been anticipated because it is apparent that, quite separate to the fundamentals -- China’s economic slowdown, the eurozone’s continuing flat-lining, Japan’s inability to ignite growth, the shale oil boom in the US -- there is what some analysts have described as the 'de-financialisation' of commodities occurring.

The unwinding of the multitude of carry trades in commodities and from developed economies to emerging economies was an obvious development as the US quantitative easing program neared its end and one that economists and market participants were talking about earlier this year.

The severity of the great commodities sell-off says quite strongly that whatever the markets had factored in either underestimated the impact of the unwinding of those trades or didn’t fully account for an unwinding that overlaid the spluttering growth in China and weakness elsewhere.

It is notable that the decline in the oil price began developing mid-year, coinciding with the beginning of a surge in the US dollar.

That was when it became increasingly clear that the US Federal Reserve Board’s quantitative easing program would end in October and markets started to contemplate the first increase in official US interest rates since the financial crisis. That turning point in US monetary policy is now expected to occur in the first half of next year.

The strengthening of the US dollar sucks capital back towards the US, and out of the myriad of carry trades that the QE programs had encouraged. While those trades are opaque, the markets should have factored their unwinding in as the Fed’s position gradually evolved.

That they didn’t fully recognise the implications of the end of the Fed’s bond and mortgage buying and the strengthening of the US dollar for commodity prices and for financial assets may be attributed to another regulatory response to the crisis, the Volker rule, that limits principal trading by US banks.

In July, in a KGB Interview, Credit Suisse’s chief economist, Neal Soss, suggested that the post-crisis regulatory environment in the US could affect the ability of markets to respond flexibly to pressure.

‘’I think one of the risks under current circumstances arises from the intersection of tightening (US monetary) policy …and the new regulatory environment that makes it very difficult for the dealer community to have an elastic balance sheet to achieve the risk transfer from people who want to sell securities to other people who are willing to buy them,’’ he said.

The limits on principal trading, higher capital requirements and more stringent liquidity rules have reduced the capacity of banks and investment banks to act as either principals or middlemen and therefore have reduced liquidity and exaggerated the volatility in markets.

While Soss thought the market had priced in most of the risk of US rates starting to rise next year and had time to factor in the rest it would appear that he, and the market, may have under-estimated the scale and breadth of the carry trades and the sheer volume of funds that flowed towards emerging market credit, into commodities and into higher-risk assets. It is notable that the US junk bond market, which had been booming, has experienced a major sell-off.

In other words, apart from the fundamentals of over-supply in oil and other commodity markets against the backdrop of big increases in production and slowing growth in demand, we may be seeing a series of correlated asset bubbles now deflating rapidly as trades are unwound.

That is causing some currency shocks and, judging by the behaviour of bond markets, could result in both corporate and even sovereign defaults. There are concerns about Russian bonds and real fears that Venezuela could default. The impact on Middle Eastern economies of the lower oil prices could generate its own flow-on effects as petrodollars are repatriated.

There’s always been a major question mark over whether the US could end its QE programs and transition towards more conventional monetary policies and positive interest rates without causing major disruptions to markets.

There was an ancillary question mark over the implications of the new financial sector regulatory architecture for any severe bout of turmoil in markets and/or economies and how the markets for both financial and real assets could be affected if they were subjected to severe pressure.

In a speech in Sydney earlier this year, the special adviser on financial markets to the OECD secretary-general, Adrian Blundell-Wignall, said there had been a "huge super-highway of money" flowing into emerging market credit in search of higher yields than those available in developed economies with their ultra-low interest rates.

"The question," he said, "is whether this super-highway is a dual carriageway."

The across-the-board sell-off in commodities and higher-risk, higher-return financial assets would suggest that it is.