You Fight Real Physical Inflation With Rate Hikes, Not Talk of Rate Hikes; Buy the Dip in Commodities, Gold Underpriced - Goldman Sachs

June 18, 2021 8:51 AM EDT

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Goldman Sachs analyst Jeffrey Currie notes that physical markets are ignorant of the Fed. For him, the recent rally in commodities has been underpinned by strong physical demand and scarcity and not inflation risks nor Fed forward guidance.

“The only thing that can fight real physical inflation is rate hikes, not talk of rate hikes. As we have emphasized in the past, commodities and the physical markets that make up the CPI are ‘spot’ assets that are mostly void of expectations and are determined by today’s supply and demand where the talk of potential rate hikes two years from now is entirely immaterial, particularly when such talk drives down the far more material 10-year yield,” the analyst said in a note sent to clients.

Fed’s latest talking activity is another opportunity to buy the dip in commodities, Currie notes, although a recovery from the latest dip may take longer than in the prior occasions.

“Financial markets are ‘anticipatory’ assets and almost entirely driven by expectations and hence talk. As a result, the Fed’s comments, like China’s comments several weeks ago, are designed to minimize financial market volatility, not fight inflation. Ironically, fighting inflation requires substantially increasing market volatility through high and large enough rate hikes to slow strong physical demand. Yes, China has now positioned itself to potentially use its strategic reserves of metal - and copper in particular - to calm prices, but this will only feed the insatiable US and EU appetite for commodities that has just now been marginally increased by the Fed through lower yields.”

Long oil is a high-conviction trade at Goldman Sachs, which sees Brent oil averaging $80/bbl this third quarter.

“Global demand likely rose to 97.0 million b/d in recent days from 95.0 million b/d just a few weeks ago as the US passes the baton to Europe and EM, where even India is beginning to show improvements. Prompt timespreads in a basket of Brent, WTI, and Dubai, which are the best indicator of market tightness, rallied to multi-year highs this week. With such robust demand growth against an almost inelastic supply curve outside of core OPEC+ (GCC + Russia), the global oil market is facing its deepest deficits since last summer at nearly 3.0 million b/d. With refiners quickly responding to small improvements in margins, petroleum product supplies have broadly matched this jump in end-use demand, leaving this deficit almost entirely in crude. We expect further demand increases towards 99.0 million b/d by August of which half can be accounted for purely from DM seasonality alone.”

Gold is underpriced and trading in oversold conditions, Currie stresses and urges investors to get on the long side as the bounce is likely.

“In a now familiar pattern, the recent gold move has outpaced both the move in the dollar and in real rates, indicating it is due for an upward price reversal in coming weeks. In fact, gold is now pricing a Goldilocks scenario of strong growth without any inflation, implying limited demand for it as either a defensive asset or inflation hedge. This perfect scenario seems unlikely to materialize for two reasons. First, as our rates strategists noted, the current 10-year breakeven inflation rate is too low vs our economists projected inflation path - in fact it implies almost no inflation risk premium in coming years. Second, should the Fed’s expectation of transient inflation materialize, higher rates will begin to act as an unnecessary headwind to the global recovery, damaging growth expectations, and raising gold’s defensive value. As financial conditions haven’t materially tightened after the announcement, the degree of stimulus to the real economy - and hence inflation - remains unchanged. Taken together, we see gold as under-valued relative to both real and nominal fundamentals.”

The analyst also sees a buying opportunity in copper, although doesn’t rate the market as strongly as oil.

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