Pressure on Safe Assets, Who Will Relieve the Pressure

Money is Going Risk off and Maybe for Awhile

Asset classes are starting to show convincing aversion to risk. Economic indicators being what they are, it’s not surprising that we see market declines to levels noticed last December and January. Back then, markets found revival in the European Central Bank’s (ECB) two Long Term Refinancing Operations (LTRO) conducted in December and February.

ECB operations pumped some 1 trillion euros into European banks, with the euros inevitably finding their way into markets. Now, markets are again showing signs of insecurity. But with ECB’s balance sheet, who has the capacity to spur another market revival?

Revealing is a May 11 Reuters article by Barani Krishnan wherein hedge funds decreased their long positions in commodities by 20% or $18 billion as of May 8. Based on Commitment of Traders (COT) data produced by the Commodity Futures Trading Commission (CFTC), Kirshnan’s article continues by pointing out that money last flowed out of commodity long positions to this degree was in January…Prior to the ECB full 1 trillion euro effort.

Return of Sentiment Driven by Europe: Commodities

Looking at asset classes, Reuters-CRB Commodity Index is a decently diversified commodity index. Included are grains, copper, cotton, live cattle, lean hogs, sugar, orange juice, gold, silver and of course crude oil. All told, commodities are considered high risk, and when they look to go down, money will leave them.

Currently the index sits at 524.61, which is lower than its pre-ECB intervention December number of 547.22. Following the completion of ECB liquidity infusions, CRB index reached a high in February of 601.86. Current numbers show a decline of 12.84%, and with weak economic numbers, organic commodity demand seems declining. Long term, commodities demonstrate a convincing down trend since May, 2011. Such declines are certainly associated with completion of U.S. quantitative easing.

Add to the current commodity situation, a rising U.S. dollar and further pressure bears against commodity prices. Commodities are priced in dollars, when the dollar increases, commodities often decrease. The apparent reason is when one pays for a commodity in foreign currencies, it takes more foreign currency to meet a rising dollar, which blunts demand.

Dollar Appreciation and Yield Declines

Speaking of the dollar, it’s increasing in value as a safe haven currency. Just as commodities declined last January amid market insecurity, the U.S. dollar index gained in value. In January, as commodities declined, the dollar index hit 81.53. Once the ECB intervened with their LTRO, dollar index relaxed to 78.26 but now sees itself rising at 80.61. For an index that moves little, such moves tell of significant market sentiment. Currently, sentiment seeks safety and opposes risk.

Indicative of direction among safe haven assets is also U.S. Treasuries. When demand for treasuries, or bonds in general, increase so does price while yields decrease. For the 10 year Treasury Note, it shows dramatic price increases and yield drops when European concerns grow.

Pricing of this instrument grew dramatically starting last spring, perhaps in anticipation of the Fed’s QE2 concluding and, of course, the then existing European problems. It then traded sideways through ECB’s LTRO with some deep declines. Now, it is shooting up in price like a rocket. Overall it tells of sustaining mid-term caution, and a favored refuge against market insecurities.

Dollar appreciation can present economic challenges for U.S. growth by making exports relatively more expensive. Progressively declining yields can also generate economic challenge. Where the ECB previously took strain off these dynamics, will these dynamics grow worse or just stop by themselves. Looks like the ingredients of a QE3 could be in the mix, but can it be of the sort seen with the last two rounds given political sentiment.

Rates of U.S. economic growth will factor the most in whether the Fed takes action. Regardless of Fed action, the underlying issue resides in Europe and is something QE3 can't fix.