Here's why commodities have sold off over the past several days
Look out below. The prices of most commodities are falling faster Spitzer's pants at the Mayflower Hotel. In my opinion, the main reason why commodities have sold off over the past several days is that hedge funds have been unwinding their over-leveraged positions. A few major financial lenders recently instructed their hedge fund clients to reduce their “leverage” in the commodity markets. Most of these hedge funds were very highly leveraged, holding the maximum number of futures contracts that their capital positions would support. What started as the selling by a few hedge funds as theyn reduced their leverage snowballed into a mass liquidation of commodity positions as other investors got spooked and sold their positions to lock in their substantial gains.
The CRB commodity price index which measures the prices of 19 separate commodities fell 4.6% yesterday. Sugar futures fell more than 11% in one day. Coffee prices yesterday dropped almost 10%. Crude oil futures fell 4.1%. Gold prices have fallen $113 per ounce in the past 48 hours from a record high of $1,033 to $919. Corn and soybean futures were down the daily trading limit.
The selling in the commodity markets continued overnight. The dollar is posting a strong recovery from the recent lows. Gold prices fell another $25 to $920. Silver is $1.20 cents lower. Crude oil is below $100. Soybean futures were down the limit again overnight. Corn closed down the limit in all but the nearby May position.
After the selling in the commodity markets was well under way, financial reporters tried to come up with a fundamental justification for the sell-off, such as the U.S. economy is in a recession, the Fed might be done easing, the value of the dollar is rebounding, demand from China is slowing etc. The fact of the matter is that over the past several months, hedge funds have bought a record number of futures contracts in all the commodity markets. The positions held by these funds were so highly leveraged that only the slightest tightening of credit created a domino effect.
In the past it has seemed to usually take at least three days for the fund selling to run its course when a major market correction occurs. This time, given the massive size of the fund positions it may take longer. Furthermore, today is the last day of trading before a three day weekend and many traders are always hesitant to hold their positions going into a normal weekend, let along an extended one.
Keep an eye on oil and gold. Once they begin to stabilize other commodities should as well. We probably overshot a little on the upside on a number of commodities, but I plan on hanging on. The long-term bull story for most commodities remains intact. The demand for increasing amounts of and higher quality food in emerging markets isn't going anywhere, neither is the U.S. government's absurd ethanol policy (for now). There haven't been any major oil discoveries or miracle breakthroughs in alternative energy over the past week that change the fact that the world's appetite for the finite supply of oil is going to drive prices upward in the long run. The dollar will likely continue to fall as the bloated U.S. deficit continues to grow and the Fed has to cut rates again to fix the problems in the economy. Times like this are painful, but they are inevitable. Nothing ever goes straight up, even when there are such compelling arguments for why long term the prices of most commodities will increase in dollar terms. Have a great long weekend.