What is the link between Sensex and your wheat and corn? Or what connects the bloodbath in stock exchanges across the world and commodities market.
If you want to know what happens to your soya and sugar prices when share markets crash in China or US, read on.
In 2006, commodity markets attracted money from some very large non-traditional investors from pension funds and indices traders.
Slowly, these rich punters started dominating commodity markets because their deep pockets allowed them to accumulate fairly large positions in any commodity.
Hedge funds, which manage about $1.3 trillion worldwide, are loosely regulated private investment funds that seek to profit from new opportunities using alternative investment strategies.
About 8,000 hedge funds trade globally. Commodity trading hedge funds returned between 13% and 23% last year. Global investment in commodity funds doubled to $24 billion in 2006 and may rise 25% in 2007.
In the US, these non-traditional players on Nymex, CBoT and NyBoT became so numerous that the local regulator, CFTC, decided their trading positions in each commodity should be listed separately in its weekly market round-up. More on that later.
In India also the same thing happened with non-traditional players moving in when stock market traders decided to invest in commodity futures as a way of expanding their risk portfolio.
Again, futures are a highly leveraged game. By putting upfront a small amount of initial margin, one can acquire positions in commodities worth several times over.
Even this margin money is not without risk. If value of the commodity one bought alters, one is expected to put in more cash as variable margin. If one does not have money at that time, one has to exit the market with a loss.
When the markets are relatively placid and less volatile, punters face little risk. But a sudden upheaval can kill. That is what happened last week when the Shanghai stock exchange saw its biggest fall in a decade and Wall Street had its worst day since the aftermath of the 9/11 attacks.
Shares began to look risky. Hedge funds and other financial institutions had to suddenly find money to either meet the margin calls on their equity portfolio or sell out. A relatively painless way of doing it was to book profits by selling off their positions in the commodities market. With the big punters heading for the exit together, the meltdown in equity markets was repeated in the commodity exchanges.
When funds liquidated their positions on commodity exchanges, it brought prices of wheat, sugar, coffee and cotton down. The worst-hit were soya and corn. In metals and bullion, there was an additional factor.
Gold is usually a natural hedge against inflation. But traders reasoned that if the Chinese economy slows down along with possibly the US economy, then there would be less demand for goods and services and therefore, a lower threat of inflation. So, speculators headed for exit.
The secret is out
Giant index funds and swap dealers are looming so large over the international markets for food, beverages and fibre that the US government has begun disclosing their trading positions separately to other market players every week.
This move confirms the worrying impact of their asset reallocation strategies on the global prices of sensitive commodities like wheat, corn, cotton and sugar in the past one year. Last week, the share of index traders in total open interest ranged from a huge 39% in wheat on CBoT to 28% in sugar on NYBoT.
Commodities have risen sharply in popularity last year. Index funds are investing in indexes such as the Dow Jones-AIG and Reuters/Jefferies CRB. Pension funds, endowments and other institutional players are also investing in commodities in a big way to diversify their assets.
A lot of investment banks are also buying futures to carry out physical commodity trades for their clients. Last week, these index fund traders were having big positions in coffee, sugar, cotton, and cocoa.
Acknowledging the importance of this new trading reality, the Commodity Futures Trading Commission (CFTC), the US exchange regulator, believes that a significant proportion of the long-side open interest in a number of major physical commodity futures contracts is held by so-called non-traditional hedgers such as swap dealers.
