The Hightower Report

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The outlook for the US economy seems to have become more suspect over the last month. During that timeframe, however, a prevailing trend of general Dollar weakness over the third quarter of 2010 was cast aside. The turning point came earlier this month when the Federal Reserve’s Open Market Committee announced that they would use proceeds from maturing mortgage debt to buy Treasuries, well short of potential action that may have undertaken. There has been little indication from recent US economic numbers that these steps will be anywhere close to changing the outlook for the US economy. More likely than not, this will only be the first step in what will be more substantive activity in the future. While the Fed’s “wait and see” attitude towards US quantitative easing put a scare into global equity markets, it also removed the Dollar’s tendency to receive safe-haven support. Of the two currencies that have taken up the market’s flight to quality, the Yen has seen the larger move to the upside. With Japanese officials being hostile to this current Yen strength, however, it is conceivable that central bank intervention may turn any moderate pullback from 15-year highs into a full-scale meltdown.

A more suitable choice to benefit from an extended period of Dollar weakness would be the September Swiss. Unlike Japan, Switzerland’s economy has been comparatively strong over the past year with better conditions and a better outlook than many of its European neighbors.  This has allowed it to receive safe haven support not only from the Dollar, but from any risk flare-ups within the Euro zone as well. Recent disclosures that the Swiss National Bank had taken heavy losses during their period of active currency intervention fed into the Dollar’s recent recovery, and sent the September Swiss back towards the lower end of this quarter’s trading range. The ability to limit these losses, as well as holding onto the large gains from the rally in June, are a strong indication of the upside potential for the September Swiss if the Dollar makes a return to this month’s lows.

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Natural gas prices continue to decline and so far have been down about 16.5% in August alone. This has now pushed prices back down to the bottom of a four and a half month base at 4.25 to 4.140. Coincidentally, these low levels have served as a quasi-deflationary price low throughout the year as economic slowdown fears reach a fever pitch. Short term supply is high, as storage levels stand 219 bcf above their five year average and continue to build. Elevated levels of natural gas production are expected to continue, as producers exploit prolific onshore fields (shale). Additionally, the latest Baker Hughes data pegged the U.S. natural gas rig count at 992, just below the psychological 1,000 mark.

The latest EIA Short-Term Energy Outlook estimated 2010 production to grow by 1.9% to 61.1 bcf per day. Increased production in the face of sluggish demand has served to hammer natural gas prices by more than 30% since the start of the year.

We believe there will be one more push down in natural gas prices to come, and that should take prices down to new lows for the year.

Despite the bountiful supplies, there are signs of life on the demand front. The EIA forecasted overall natural gas consumption to increase 3.8% from 2009 levels to 64.9 bcf per day, which provides a 3.80 bcf per day shortfall to help sop up excess supply.

At current price valuations, it would appear that natural gas has virtually no weather premium priced in, and with peak hurricane season now upon us, prices could jump in a hurry. While inventories remain well above their five year average, that gap has contracted for eight straight weeks and is now just under 8.0%. This tightening has narrowed various spread relationships, which has greatly reduced the incentive to build inventories.

The steep decline in prices has also attracted speculator selling and has pushed the spec net short position to extreme levels. If we discount the 2008 financial meltdown, the current position is nearing the 2007 extreme that occurred when natural gas was trading at around $6.000.

As mentioned earlier, we expect the slide in natural gas to continue and post new lows on the year to $3.800-$3.850. This has the potential to trap shorts into the market at a time of “cheap” valuations.

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The U.S. economic outlook continued to deteriorate into the middle of August, with fears of a double dip recession growing almost daily. The Federal Reserve apparently isn’t concerned though, as they have not rushed to the rescue with additional easing efforts beyond the Federal Reserve’s Open Market Committee announcement on August 10th that they would use proceeds from maturing mortgage debt to buy Treasuries. With recent CPI readings depicting a greater chance of deflation rather than inflation, it wasn’t surprising to see a number of U.S. Treasury yields reach fresh, historically low levels. In retrospect, the September Treasury market has managed a very surprising 8-point rally from the late July lows, where previously it appeared that the Treasury market was poised to roll over to the downside! However, news that China has reduced their holdings of U.S. Treasuries for the second month in a row coupled with increased vulnerability in the Dollar may reduce the attractiveness of U.S. Government securities.

The monthly U.S. payroll report was disappointing and U.S. manufacturing readings have been soft, making it difficult to turn the upward trending Treasury market around. U.S. 2nd Quarter Productivity showed the first decline in six quarters with results that were below expectations. June Wholesale Inventories and Sales figures both came in below expectations and served to add to the already fragile sentiment. Foreclosures in July jumped to nearly 93,000 units, up 9% from June and up 6% from a year ago.

With the recent appreciation of grain prices sparking global inflationary fears, the falling Dollar and the potential for reduced interest from China, one of the most important holders of U.S. debt, we suspect that U.S. Treasuries are beginning to look really expensive. A very significant top might be in the offing over the coming month.

The threat of a continued longer-term downtrend in the US dollar might provide some temporary support to the commodity market sector, but it will be more important to see an expanding global economy for commodity markets move higher. If the sluggishness of the US and European economies spreads to China and other emerging markets, recessionary demand will return to the commodity markets.

Fund traders hold aggressive net long positions in many agricultural markets, so a shift in psychology should not be taken lightly. A number of factors could leave fund traders in a position to “throw-in-the-towel” on the long side of the commodities play. A few concerns which come to mind include:

1. China’s demand slows if their housing market bubble bursts.
2. India begins to export cotton, wheat, rice and sugar on the world market, which may dispel some beliefs that world supplies are extremely tight.
3. Energy supply continues to swell.
4. New regulations aimed at speculators have unintended consequences.

There are certainly plenty of factors that could spark sharply higher commodity prices, including weather, but we see many commodities in general as being too overbought given their supply outlooks. It will take strong global demand growth in just to rationalize their current price levels. We would caution traders to consider buying only in markets with supportive big picture fundamentals.

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The devastating drought which still has no sign of abating in the Black Sea region has been the primary bullish factor supporting the surge in wheat prices in the past month. December wheat put in a low of $4.85 per bushel on June 30th and posted a high of $8.68 on Friday, August 6th, a gain of 79% in just 27 trading sessions. End users were forced to make a sudden adjustment from an oversold and down-trending market with growing surpluses to the sudden loss of tens of millions of tonnes of supply from Russia, Kazakhstan, Ukraine, Canada, Germany, France, Hungary, Bulgaria, Morocco and elsewhere. We believe the rally into the August 6th peak may be just an “adjustment” spike and that the market will soon return to more of a trading range back down to the 625-725 zone basis December wheat.

The wheat market is making a shift from weather-related production losses to a scramble by major importers to book sales before prices move even higher. Many importers such as Egypt will need to diversify their supply sources. Egypt is the world’s largest wheat importer, and they have become almost completely dependent on Russia over the past year due to lower shipping costs from that region. Now they must get more of their wheat from France and Germany and even from the US and Australia. Record high temperatures in Russian grain areas for the past few weeks (105-110 degrees) with a lack of rain helped drive the market higher. End users, fund traders and producers were caught out of position and the adjustment has been fast and furious.

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A number of developments have surfaced in recent weeks that have boosted the appeal of gold. The most recent one comes out of China, where the government introduced policy changes that would encourage development of the country’s gold market. Some of these new measures would allow the four biggest state-controlled banks to trade gold bullion. As it currently stands, China is the world’s largest producer of gold and holds the number two spot behind India for consumption. These new measures would add more foreign members to the Shanghai Gold Exchange to foster greater liquidity while also permitting these banks to hedge gold positions. In short, greater development of China’s gold market provides a big future demand boost for gold.

It is also interesting that this development has occurred while U.S. growth prospects have been scrutinized and China has sought alternatives for its growing foreign exchange reserves. Recent chatter out of the US Federal Reserve Bank has opened the door for a new round of quantitative easing that would keep interest rates at extremely low levels. One such maneuver was highlighted in a Wall Street Journal article this week that suggested the Fed would use interest income from its portfolio of mortgage-backed securities to purchase additional securities or Treasury bonds. This threat has aroused further concerns over deflation and the monetization of debt. As a result of this fear, investors have been accumulating gold as a store of value.

Some cash traders noted a pick-up in the physical demand for gold as prices traded under $1200/ounce.

From a technical perspective, October gold is in the process of putting in an intermediate low. Prices established new contract highs in late June at $1267.10 and subsequently sold off to a late July low of $1157.50. That break also came with a drop in open interest that reduced some of the speculative participation in gold. This makes it ripe for a bullish turnaround. Interestingly, the July price low corresponds almost exactly with a 50% retracement of the February to July rally. Therefore, we see significant support at $1156.70 level, and as a result we believe the late July lows could prove to be a significant turning point for gold.

In addition, the market has penetrated the downtrend channel from the June highs, which also supports the idea that a low is in place. Traditional technical indicators were also oversold at this level as well.

On top of all of these positive forces, the market experienced all-time record high volume on the July 28th hook reversal lows, and this came in conjunction with a very small range. In other words, the market ran out of new sellers. We would expect gold to forge a rally back to the June highs at $1267.10 and potentially to another swing higher to $1306.70.

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The long and winding road toward a global recovery continues to encounter tight hairpin curves and an occasional roadblock. Last week, just when it seemed like most markets were poised to fully embrace a return to double-dip recession conditions, sentiment pivoted and improved significantly. Apparently the mere hope of accommodation from the BOE and the US fed provided the impetus for the recovery in attitudes, but it is also possible that a flurry of mostly supportive US corporate earnings and a further downshift in Euro zone debt fears also contributed to the revival. One might also suggest that a final end to the push for financial reform removed a layer of anxiety that had been hanging over the market for most of the last 6 months. However, until the flow of US scheduled data shows some improvement again, we would label the gains in stocks and certain physical commodity markets as rather suspect. With the renewed concern toward the US recovery and the most recent “quietly orchestrated” push for another extension of US unemployment benefits, it is possible that US financial instruments might be viewed with some suspicion by foreign investors.

With the US Dollar seeing a two-month slide and US Treasuries only able to manage a two month consolidation below contract highs, it would also appear that some flight to quality interests are already pulling away from the US Dollar and US Treasuries. While we don’t see the US credit rating called into question anytime soon, in the event that the numbers remain soft and the next non farm payroll report shows another big loss, the onus could be on Washington to do something other than extend unemployment benefits. While Harvard and other politically correct institutions of higher learning might be able to produce studies that ferret out some abstract stimulus effect from extending payments to the unemployed, to get “self perpetuating” growth might require some tried and true classic stimulus efforts.

While China and other important world entities have signaled their ongoing interest in US Treasuries, it is not a given that another round of deficit spending from the US will go off uncontested. Therefore, we see the potential for even more slowing ahead and a major political/economic decision might have to be made by Congress and the President in the coming month. While physical commodities like oil and metals are sure to be dramatically impacted by the recovery/no recovery situation, we think the tell-tale markets will be the US Dollar and perhaps the US Treasuries.


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For much of the past three years, the copper market has been a very solid leading indicator of where the economy was heading. While some might suggest that the mid July rally points to a possible recovery ahead, it is more likely that the market reached an undervalued level below $2.80 and it needed a corrective bounce. The subsequent rally from the sub $2.80 low to the $3.10 area was accomplished at least partially on the back of a gradual tightening of supply at the exchanges, but it was also partially forged off speculation of a recovery in the wake of a reduction in European contagion fears. In looking at daily and weekly changes in world copper exchange stocks, the LME has shown a very definitive pattern of daily declines. The Shanghai exchange has also seen a tightening of supply. Since March 3rd when LME copper stocks began to decline in earnest, that exchange has lost approximately 131,650 tons of copper and saw declines on 87 out of 97 days.

Some might even suggest that changes in Shanghai copper stocks are even more critical to world copper prices, as China has become a dominating demand force in the market. Therefore seeing Shanghai copper stocks drop in 8 of the last 10 weekly readings for a total decline of 60,902 tons would seem to suggest that China is still growing or that China has for some reason decided to reduce its buffer stock of copper. It should also be noted that the International Copper Study Group last week put the world copper market in a 60,000 ton deficit in the month of April, and that highlights a market that has remained tight even in the face of some rather slow economic activity. In the end, we would suggest that copper is a commodity market that should sense the end of the slowing first and in turn see the biggest reaction to a return to positive growth expectations.

However, with December copper recently climbing back above $3.10 and those prices sitting more than 10 cents off the early July lows, we would caution traders to buy copper cheap and avoid paying up near the upper end of the last two months’ trading range. In our opinion, the copper market is likely to encounter another disappointment in the lead-up to and through the next US Unemployment Report, and the realization of a sluggish US economy is certainly capable of knocking December copper back down to the $2.89 level. While the US and European economies might not be able to return to the robust growth seen prior to the sub-prime crisis, seeing the US and Euro zone become less of a drag on global demand could make a late July or early August correction in copper a chance to get in on what could be a pretty solid uptrend through the end of this year.   

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The impact of the sub-prime crisis continues to serve as a drag on the global economy into the 3rd quarter of 2010. As suggested in our last newsletter, the evidence of slowing in the US economy has become more prevalent throughout a wide range of statistics over the last month and that in turn has created a fresh drag on physical commodity prices.

We also suggested in prior publications that a number of physical commodities like soybeans, sugar, crude oil, RBOB, heating oil and natural gas are pretty flush with supply right now. Fears on the demand side are, therefore, something that should be expected to weigh on price structures.

Ordinarily we would have expected some response from the government to recent evidence of slowing but our Congress gets a full week off for the 4th of July, perhaps so they can take advantage of their superior health care benefits and be fully rested when they get back. Complicating the move toward additional stimulus measures are international concerns toward deficit spending and apparent fundamental differences within the government on what type of stimulus measures actually work.

While the jury is still out on whether extending unemployment benefits is a stimulus, those benefits were included in the original record stimulus package and it doesn’t seem as if the country is garnering a sustained benefit from that spending. However, given that the Democrats have a solid majority and also the White House, we suspect that a noted portion of any additional stimulus will be directed by the California and Nevada Congressional contingents toward unemployment benefits extensions.

We have to wonder if key members of the G20 won’t begin to complain that the US is using borrowed money for suspect programs. Therefore, the international response to an upcoming US stimulus push might serve to reduce the flight-to-quality status of the US Dollar and the US Treasury markets. While we aren’t expecting an all out discussion of a downgrade of the US debt rating, it is possible that money won’t be as aggressive in flowing toward US financial assets.

In the event that the President dares to dream big and Congress puts together another massive pork barrel package, it is possible that global market players might attempt to shape US policy by their investment flows. While China recently suggested that would not abandon US Treasuries, they reportedly held in excess of $900 billion at the end of April. Therefore, they do have the power to influence US policy decisions. We see the prospect of the Dollar weakening ahead but we doubt that factor alone will be capable of turning off a pattern of weakness in physical commodities.

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The USDA will issue its July Supply/Demand report on Friday, just after this writing and the report is likely to show a tight ending stocks forecast for the end of the 2009/10 season which would lead to smaller beginning stocks for the upcoming crop season. In the process of pricing in both a near-perfect start to the crop season and improving crop conditions in May and June, December 2010 corn pushed to a life-of-contract low ahead of the key USDA reports on June 30th.

The USDA Planted Acreage and June 1st Grain Stocks reports were considered very bullish, and prices have already jumped as much as 13.5% in just 4 trading sessions. This suggests that a major low could be in place. The corn market seems to be in a position to move higher over the near-term, and it seems to have some of the key characteristics to attract interest from large money managers and fund traders as a “buy and hold” commodity.

Planted acreage was revised lower to 87.87 million acres, as compared with 88.8 million acres on the March report and expectations of a 400,000 to 600,000 acre increase from that March forecast. This was below the low end of the range of trade expectations. June 1st stocks came in at 4.31 billion bushels, which was roughly 290 million bushels below trade expectations. The stocks number implies much better than expected demand for corn during the past quarter, and this suggests another significant revision lower for 2009/10 ending stocks. In the long run, the 2009 crop was probably overestimated. However, there is still talk that the lower quality of the 2009 crop meant that it took more corn to produce the same amount of ethanol and to feed animals to the same weight. With lower beginning stocks and lower plantings for the 2010/11 season, the ending stocks forecast is likely to tighten.

However, yield is also likely to be revised higher. Even if we revise yield to a record 168 bu/acre, when we plug both the lower beginning stocks and lower acreage numbers, ending stocks come in at just 1.526 billion bushels. If yield is a lesser record at 166 bu/acre, ending stocks slip to 1.365 billion bushels with a tight 10.2% stocks/usage. If we see late season heat and some dryness from mid-July through mid-August, some of the later planted corn crop could see unfavorable conditions for pollination and this could clip yield enough to cause a significant tightness in the corn supply outlook. The development of above normal heat recently, with more heat expected in the long term forecast, may trim yield forecasts as this is occurring as the corn crop starts to pollinate in key growing areas.

Nighttime lows will also be watched closely. If they remain above 80 degrees, this can seriously hamper the pollination process. Traders noted that plant populations have increased in corn fields in recent years and that this increased concentration of vegetation raises the temperature in corn field above that of the surrounding air. This could cause added stress and lessen the ability of the crop to cool down at night which is necessary for an optimal pollination. For example, if actual average yield comes in at 161 bushels/acre, still the second highest on record, ending stocks slip under 1 billion bushels and stocks/usage drops to just 7.2%. Stocks/usage has been under 10% only two other times since 1973 and this would suggest a December corn price of near 5.25 to 5.65 into late August.

Crop conditions have deteriorated in the past two weeks due to too much rain, especially in Iowa. The good-to-excellent corn rating dropped to 71% as of July 4th versus 73% the previous week and 75% two weeks earlier. However, Iowa conditions fell to 65% from 72% last week and this is a growing concern for the market. However, pollination weather looks near ideal for the corn crop until or unless extreme heat moves back over the Midwest for the July 17th to 24th timeframe. Many weather models are showing this feature and this could clip the yields for some of the late planted crop. Silking stands at 19% as of July 4th, well ahead of last year’s 8% at this point. This is also ahead of the 5-year average of 12%. Silking is the best indicator of the start of pollination although the corn plant starts to shed pollen slightly before silking and it continues to shed pollen for several days thereafter. Weather conditions are critical during this period since the plant will not shed its pollen if conditions are wet or too hot. The reason that pollination is critical is that each silk that is pollinated produces a kernel on the ear of corn. If there is uneven pollination, there will be fewer kernels which means fewer bushels per acre regardless of how favorable late season weather may be.

The Commitments-of-Traders report for the week ending June 29th showed heavy net selling by funds. Trend-following (managed) funds were net sellers of a whopping 50,221 contracts to switch their net position back to the short side at 39,426 contracts. The reporting period ended on the day that the December contract posted its recent low at 343 1/4, just ahead of lthe USDA’s Acreage and Quarterly Stocks reports. Therefore, trend-following funds may have gotten themselves trapped on the short side ahead of the USDA’s reports, and that could provide a foundation for significant fund buying ahead if weather is even mildly stressful and prices continue to advance. For example, if trend-following funds simply return to the 4-year mid point of their position in corn, this would be a switch from the current net short position of near 40,000 contracts to a net long of 120,000 to 160,000 contracts.

Other factors which could support the corn market in coming weeks are the China production outlook and the recent collapse in the US dollar. If the dollar sees increased pressure ahead, commodity markets in general could be well supported. Major corn growing areas in North East China have received substantial rain over the past weekend but conditions are still looking variable depending on location. Parts of the north China Plains are still showing excessive heat. If China’s crop comes in smaller than expected, imports could be significant. The rains were very welcome as dry conditions and above normal temperatures in that region in recent weeks had raised fears of a drought. Some areas are still seeing temperatures of 95 to 105 degrees in the China plains which may impact yield.

Keep in mind, a near record yield of 164 bushels per acre will leave the stocks/usage at only 9%, the second tightest since 1973 and a level which might spark aggressive pricing from end users.

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We had some very bad US data again today, but Treasuries weren’t been able to extend sharply to the upside, which leads us to believe that we might be near a major inflection point. While the Euro zone situation isn’t fully solved by any measure, we think their debt contagion has been moved to the back burner and that the slowing of the US economy and its soaring deficit problem might become the media’s new obsession. With the battle lines drawn in the recent G20 meeting, the US is already setting the stage for divergent policy decisions. Perhaps the US leadership was already aware of the vulnerable status of the US economy, but since Washington won’t do standard textbook stimulus efforts the US might be in for a return-to-recession status.

The world has already bid Treasuries into the stratosphere due to their flight to quality status and because of evidence of US slowing. But today the Treasury rally seemed to run out of gas, and the US Dollar appears to have finally caved in. This suggests to us that world sentiment is changing and that further slowing in the US could mean a flight from the US Dollar and from US Treasuries. While gold was down sharply today, the world might have little choice but going to gold because of the almost total absence of a sturdy currency.

It would appear that the US will now be forced to provide more quantitative easing or perhaps even another stimulus package. Since the current US Administration would rather shoot itself in the foot than to utilize standard economic principles in their easing programs, it is possible that US Treasuries and the US Dollar are poised to go from the “penthouse” to the “outhouse.” In our opinion the Democrats won’t/can’t change their principles of only helping those who don’t have a job, are not wealthy and don’t work on Wall Street. This means the Democrats are going to be faced with market action ahead that could insure a house cleaning in the November elections.

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