Big spikes for coffee and natgas show end of commodity correlation

NEW YORK Thu Feb 20, 2014 6:28pm EST

Coffee beans are seen in the roasting area at Sightglass, a coffee bar and roastery, in San Francisco, California May 8, 2013. REUTERS/Robert Galbraith

Coffee beans are seen in the roasting area at Sightglass, a coffee bar and roastery, in San Francisco, California May 8, 2013.

Credit: Reuters/Robert Galbraith

NEW YORK (Reuters) - Investors looking for more evidence that a years-long correlation between commodity prices and financial markets is well and truly dead have found it this year in two of the industry's more remote corners.

Fueled by extreme weather conditions in both hemispheres, benchmark U.S. natural gas and coffee futures prices have surged about 50 percent this year, after languishing out of favor for years.

The ferocity of the gains -- including a more than 10 percent jump in both markets on Wednesday -- has taken traders aback, with some suggesting that momentum traders and hedge funds may be rushing into a fundamental rally late in the game.

But the gains also speak to a larger phenomenon that has transformed commodity markets over the past year, as major raw material indexes -- and the commodities they track -- decouple from stock markets and foreign exchange rates to chart an independent course, ending a five-year period of unprecedented correlation following the financial crisis.

Market-specific fundamentals, rather than macro-economic concerns or cross-market trades, are likely to exert themselves more in the future as the Federal Reserve winds down its bond-buying binge, slowing the flood of money that aided riskier assets, according to traders and investors.

"With natgas and coffee, we have probably seen the most stark example of what could happen when commodity markets become totally independent," said Ernest Scalamandre, founder of the New York-based AC Investment Management, which has about $500 million invested with commodity funds.

The rapid onset of an exceptionally harsh drought in Brazil has fueled fears of a sharp drop in arabica coffee supply this year, while the worst winter in decades in the United States has caused demand for natural gas used in heating to surge.

Arabica coffee scaled 16-month peaks on Wednesday, after vaulting 20 percent in just two sessions as funds continued to focus on the impact of dry weather on Brazil's crop. Natural gas is at five-year highs, gaining 22 percent this week even with the winter season nearing its end.

To be sure, this is not the first time for some commodities to break ranks. Corn and soy rallied in 2012 driven by a U.S. drought; cotton futures surged in January last year after speculators crowded the market.

But for several years after 2008, key commodities such as crude oil, gold, copper and cotton, and even niche markets like platinum and sugar, moved in lock step sometimes with equities on concerns of whether the Fed would continue to stimulate the U.S. economy and whether recovery in the euro zone would falter.

Now, they are more often steered almost entirely by their own drivers, with oil often moving to news of pipeline disruptions and other supply factors versus the strong company earnings that have driven U.S. stocks to record highs.

The positive correlation log between the 19-commodity Thomson Reuters/Core Commodity Index .TRJCRB and the S&P 500 stock market index .SPX averaged a 0.5 reading over most of the past five years. This year, it has averaged less than 0.15. A reading of 1.0 denotes perfect correlation.

RIGHTFUL ORDER

For many, the change is evidence of a return to the rightful order of things, with passive investor fund flows that were often blamed for the increased correlation now receding.

"I think we will ultimately revert to what it looked like in the '80s and '90s, where the only commonality between the price of an equity and a commodity was basically the GDP," Scalamandre said.

Investors plowed more than $400 billion into raw materials in a decade through 2012. Last year, they began pulling money out, particularly as gold prices fell, and total assets under management in the space shrunk to $330 billion.

At the same time, the end of proprietary trading by Wall Street banks and the failure of several big hedge funds in the space has diminished liquidity in some markets, leaving them more susceptible to the kind of spikes seen this week.

"Very little new money is coming into these markets and it really doesn't take much to move the price needle at times, so you really have to be very careful with whatever tactical strategy you have," said the manager of a hedge fund in Connecticut with nearly $1 billion under management.

Mike Hennessy, managing director at the $6 billion Morgan Creek Capital Management in Chapel Hill, North Carolina, expects to see increasing numbers of short term-oriented commodity players in the near future, distinct from long-term investors who view commodities as an asset allocation/diversification tool.

"It's not necessarily equivalent to, but is related to, momentum," Hennessy said. "Natgas was in doldrums until recently. If something doesn't work, sell/ignore; if something moves, jump on it."

(Reporting by Barani Krishnan; Editing by Jonathan Leff and Leslie Adler)