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Bank Cutting Commodities Trade Severs Link With Equities

Banks, hedge funds and other financial institutions piled into physical commodities and derivatives over the past 12 years, amplifying a run-up in prices for everything from copper to oil, in short supply before the 2008 global recession, the UN found in a 2011 study. Photographer: Krisztian Bocsi/Bloomberg

Banks’ pullback from commodities trading is weakening the link between raw materials and equities and helping to re-establish supply and demand as the main factor in setting prices, United Nations researchers say.

As Barclays Plc, JPMorgan Chase & Co. and Morgan Stanley leave parts of the business, prices of commodities are moving more independently of stocks. The correlation between U.S. equities and corn, cattle and wheat fell to less than 0.05 in January, compared with almost 0.3 in 2008, an analysis by David Bicchetti and Nicolas Maystre, economic affairs officers at the UN Conference on Trade and Development in Geneva, shows.

Banks, hedge funds and other financial institutions piled into physical commodities and derivatives over the past 12 years, amplifying a run-up in prices for everything from copper to oil, in short supply before the 2008 global recession, the UN found in a 2011 study. The exodus is nudging futures markets back toward their original function, as a way for farmers, miners and other companies in the commodities business to hedge against price swings.

“Now, we’re getting back to where strict supply-demand gives us truer pricing and hopefully better ability to look ahead,” Richard Nelson, chief strategist at Allendale Inc., a broker and consultant in McHenry, Illinois, said in an April 21 phone interview. For people who use the contracts to hedge, “it’s a completely good thing,” he said.

The weaker correlation with stocks also restores commodities’ appeal as a way for investors to diversify, according to Citigroup Inc. A correlation of 1 would mean prices moving in lockstep.

Outperforming Stocks

The research, sent in an April 15 e-mail, hasn’t yet been incorporated into an Unctad report, so isn’t an official UN statement. Unctad regularly reports on commodities’ role in developing economies.

Raw materials outperformed equities and bonds last quarter for the first time since 2008, making commodities more valuable for diversifying, Citigroup analysts led by Ed Morse said in an April 14 report.

In the next 12 months, 54 percent of investors surveyed by Barclays plan to increase their stake in commodities, compared with 27 percent who did in the preceding year, Barclays analysts led by Kevin Norrish said in an April 4 report.

“It’s time to again take commodities seriously,” Citigroup said in the report.

Job Cuts

Barclays is exiting the “majority of commodities business” while staying in precious metals, derivatives tied to the price of oil and U.S. gas as well as index products, the London-based bank said April 22 in an e-mailed statement. Barclays cut jobs in January as part of a reduction in fixed income, currencies and commodities, and shut power-trading desks in the U.S. and Europe in February.

Deutsche Bank AG, based in Frankfurt and Germany’s largest bank, said in December it would get out of dedicated energy, agriculture, dry-bulk and industrial-metals trading, cutting about 200 jobs. Bank of America Corp., located in Charlotte, North Carolina, said in January it would dispose of its European power and gas inventory as opportunities shrink and increasing regulation curbs trading.

In December, New York-based Morgan Stanley agreed to sell its oil-merchant unit to OAO Rosneft, Russia’s state-run producer. JPMorgan, located in New York, said in March it would sell its physical commodities unit to Mercuria Energy Group Ltd. for $3.5 billion, ending a five-year stint in the business led by Blythe Masters, an early proponent of credit-default swaps who said she would leave the bank.

China Slows

Goldman Sachs Group Inc., whose three top executives began their careers at the firm in the commodity-trading unit, is poised to gain market share as pressure from regulators drives competitors to scale back. The company “now has a much bigger piece of a much smaller pie,” Jeffery Harte, an analyst at Sandler O’Neill & Partners LP, said in an interview April 22.

Commodities revenue at the 10 largest banks fell 18 percent last year, Coalition, a London-based analytics company, said in February. The Standard & Poor’s GSCI Spot Index, a popular gauge of 24 commodities, fell last year for the first time since 2008 as China’s growth slowed and gold lost its appeal as a haven.

While correlations between returns from commodities, equities and bonds were unusually high after the global recession in 2008, they have dropped sharply over the past year, Goldman analysts including Damien Courvalin wrote in an April 23 report. There’s still a strong case for holding commodities in a portfolio to allow for diversification, Courvalin wrote.

The GSCI commodities index rose 4.5 percent this year, compared with a 1.5 percent gain in the S&P 500 Index of U.S. stocks and a 2.2 percent increase in the Bloomberg U.S. Treasury Bond Index.

Expanded Oversight

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 restricted banks from trading for their own account, under the Volcker Rule, and expanded oversight of commodities derivatives. The Federal Reserve is reviewing a decade-old exception to a law keeping banks out of the business of physical commodities.

Bank holding companies “should be prohibited from owning physical assets like warehouses, pipelines and tankers,” Senators Sherrod Brown of Ohio and Elizabeth Warren of Massachusetts, both Democrats, said in an April 16 letter to the Fed. “These activities pose significant safety and soundness, legal and reputational risks to the institutions.”

When conducted with appropriate safeguards, the benefits outweigh the risks, the Securities Industry and Financial Markets Association, a Wall Street lobbyist, and four other industry groups said in a letter to the Fed. Forcing banks out of commodities would make it more expensive for companies to hedge risks, the U.S. Chamber of Commerce said in an April 3 comment to the central bank.

Step Back

Anyone should be allowed to trade commodities with proper regulation, Terrence Duffy, the chairman and president of CME Group Inc., said in an April 22 interview at Bloomberg’s offices in New York. As banks step back, other companies such as independent trading houses are stepping in, he said.

The number of outstanding contracts, known as open interest, across the 24 commodities tracked by the GSCI index is still 20 percent above the average since the start of 2006, data compiled by Bloomberg show.

The GSCI Index more than doubled by the end of 2005 after falling 6 percent in the decade to 2000. It more than doubled again by July 2008, before falling 66 percent amid the global recession.

Increased Demand

Prices rose because of increased demand for raw materials as developing economies, especially China, accelerated, urbanized and lifted millions of people out of poverty. Shortages developed as China became the biggest buyer of everything from copper to soybeans. Copper futures on the London Metal Exchange gained every year between 2002 and 2007, while Brent crude oil, the international benchmark, first topped $100 a barrel in 2008.

The influx of investors amplified the “unusual” boom and bust, according to a 2013 study by two researchers at the London Business School. Institutional investors lead to higher prices, volatility and correlation with other financial markets, Suleyman Basak and Anna Pavlova said in the paper. The U.S. Senate and the G-20 opened inquiries into investors’ role in raw-materials prices.

“If you have too much, you start getting price formation that is dominated by speculation versus the physical supply and demand positioning of actors in the market,” Michael Masters, the founder of Better Markets, Inc., a Washington-based nonprofit organization that advocates for financial reform, said in an April 22 phone interview. “The tail starts wagging the dog.”

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