Weekly Fundamentals - Financial Markets Stabilized on QE Hopes but Downside Risks Remained
The commodity market stabilized last week amid expectations central banks would join hands in implementing accommodative policies to bolster economic recovery. On Friday, oil and gold prices initially slipped further but then rebounded as speculations loomed for a Spanish bailout. The ECB Vice President Vitor Constancio expected that Spain would probably request for financial assistance from the EU/IMF during a conference call among EU finance ministers. In the coming weeks, the upward momentum of the commodities under our coverage would be limited, as great uncertainty remains in the sovereign debt crisis in the Eurozone while economic data softened further in the US and China.
Earlier in the week, sentiment was lifted as G-7 leader met to discuss about ways to resolve the crisis in the Eurozone. However, as expected, no concrete plan was announced besides the pledge to support the Eurozone on overcoming the crisis. At the ECB meeting, policymakers decided to leave the policy rate unchanged and introduced no new non-standard measures. Yet, President Draghi's comments that the ECB is ready to help when needed raised optimism.
During the week, both the RBA and the PBOC reduced interest rates, reviving hopes that global economic recovery would be on track soon. The RBA lowered the cash rate by -25 bps, following a -50 bps cut in May, to 3.5% in June. After the rate cut, policymakers believed that borrowing costs have dropped to be a 'little below their medium-term averages'. In China, the PBOC lowered the 1-year lending and deposit rates by -25 bps, effective June 8. While it appeared that the reduction sizes were the same for both lending and deposit rates, the actual changes were 'asymmetric'. The headline 1-year lending rate is lowered by -25 bps to 6.31%. Meanwhile, the central bank relaxed the floor of the lending rate to 80% of the benchmark rate from 90% previously, meaning the actual lending rate can be reduced to as low as 5.048% from 5.904% (down -85.6 bps). The 1-year deposit rate was also lowered by -25 bps to 3.25%. As the PBOC also relaxed the ceiling of the deposit rate to 110% of the benchmark rate from 100% previously, the actual deposit rate can be raised to 3.575% from 3.5% (up +7.5 bps). Most banks are expected to offer the maximum deposit due to the fight for deposits among themselves. Increase in the ceiling of the deposit rate can also help mitigate the inflation risk brought about the rate cut. The move is generally a positive to the market and marks a small step to interest rate liberalization in China.
As the US economic indicators have shown signs of fatigue in recent weeks, hopes have been raised for the Fed to implement QE3. While speculations intensified after Vice Chairman Janet Yellen signaled weakness in the job market and vulnerability of financial conditions may call for the further easing, Chairman Ben Bernanke apparently downplayed the opportunity of further easing. This was the key reason for gold's plunge on Thursday.
Crude Oil: Although the front-month contracts for WTI and Brent crude oil gained more than +1% last week, the volatility of both benchmarks was high due to policy risks - investors concerned that policymakers were unable to contain the Eurozone sovereign debt crisis which has spread from Greece to Spain, and to boost growth as data from both the US and China has weakened markedly.
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For coming weeks, sanctions on Iran will come into effect. The US sanctions approved by President Obama at the end of 2011 will be effective by the end of June. The US would impose penalties on its trading partners who import oil from Iran. Countries can be granted waiver if they promise to lower their purchases crude from Iran significantly, i.e. around 20%. Currently, Japan is the only non-EU members that have been granted a waiver while countries such as South Korea, Turkey, India, Taiwan, Sri Lanka and South Africa have all lowered or have promised to cut their imports from Iran and are seeking waivers. The EU sanctions will be effective on July 1. When the embargo comes into effect, EU countries' crude imports of 600K bpd will be forbidden. Moreover, EU insurers will be prohibited from providing coverage to oil tankers that carry Iranian crude oil after July 1. Prohibition of oil tanker insurance does not only affect EU oil imports but also from all over the world, given the fact that around 90% of the world's tankers are insured via insurance pools or use reinsurance from EU companies. While the US and EU sanctions are expected to tighten to demand/supply balance, it will probably be eased by the US release of SPR, therefore, mitigating upside pressure on oil prices.
Natural Gas: declined for a third straight week. The DOE/EIA reported that gas inventory increased +62 bcf to 2 877 bcf in the week ended June 1. Stocks were +713 bcf above the same period last year and +687 bcf, or +31.4%, above the 5-year average of 2 090 bcf.
Separately, Baker Hughes reported that the number of gas rigs dropped -23 units to 565 in the week ended June 8. Oil rigs increased +28 units to 1 414 and miscellaneous rigs fell -1 units to 5 and the total number of rigs was up +4 units to 1 984 units. Directionally oriented combined oil, gas, and miscellaneous rigs added +18 units to 235 while horizontal rigs decreased -6 units to 1 177 and vertical rigs slipped -8 units to 572 during the week.
Precious Metals: Despite a rebound amid easing speculations, gold's gains were pared after the Fed Chairman Ben Bernanke downplayed QE hopes in a testimony before the Congress. Going forward, gold price is expected to continue to be influenced by Fed's (or speculation of Fed's) additional easing. The chart below shows that oil demand in the world's largest economy is a leading indicator of its employment level. As oil demand has displayed a downtrend, it implies further payroll addition would be slim, thus raising the likelihood for further easing from the Fed. This also leads to remain bullish in gold in the longer-term.
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