Sent: 13-10-2009 12:18:01
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Index Fund Impact on Futures Markets
There has been a speedy rebuilding of futures market positions by index funds since the worst of the global credit crisis, according to the special data collections by the US Commodity Futures Trading Commission (CFTC) designed to track their activities.
The volume of funds invested in futures markets by a range of investment institutions such as index funds, swap dealers, pension funds, hedge funds and mutual funds, including exchange-traded funds, had been rising prior to the global credit crisis.
The CFTC has estimated that, at the end of June 2009, these investors held long positions with a notional value of US$163 billion and short positions with a value of US$46 billion.
The largest long positions, by value, were in crude oil ($42 billion), natural gas ($12.4 billion) and gold ($10.5 billion).
Speculative activity has forever been a feature of these markets. In theory, speculators play a critically important role in funding the stock holding requirements of the industry participants in markets where commodities can be stored.
It is not entirely clear but there is some evidence that the emergence of the index funds in these markets may have changed the way prices are set.
Fund decisions about the prices at which they buy or sell tend to be less firmly based on market balances and physical usage than the decisions of traditional market participants. Fund decisions are more likely to be influenced by their own inflow of investment funds and portfolio asset allocation decisions based on estimates by investment strategists of prospective relative rates of return.
At the end of December 2007, the number of equivalent futures contracts controlled by index funds across all markets monitored by the CFTC was 3.13 million. That number rose 29% to 4.05 million by the end of June 2008 before falling 21% to 3.19 million by the end of December 2008, in the immediate aftermath of the worst of the global credit crisis.
The withdrawal of interest across these markets initially led to the impression that they would remain depressed for a lengthy period of time. Not only had the underlying market balances moved in favour of lower prices as global growth rates slumped but the inflated demand which had come through index funds also seemed to have dissipated. At least that was the initial reading of the situation.
Physical offtake clearly declined in much the same way as history would have suggested but prices have remained more buoyant than the physical market balances might have otherwise implied and they have recovered more strongly from the trough of the cycle than on previous occasions.
- The rapid acceleration in global money supply as governments and central banks around the world moved to avert a global recession would have been one factor.
- A broadly based consensus that the U.S. dollar was likely to fall in value against other major currencies helped support asset allocation decisions in favour of investments offering protection against the loss of US dollar value.
- Equity price weakness during 2008 had also encouraged investors to seek out ways of diversifying their portfolios.
- New ways of investing in commodities, such as through inexpensive exchange-traded funds, was increasing the volume of funds being attracted into futures markets.
By the end of June 2009, the number of futures contracts controlled by index funds had again risen to 3.96 million. While this was slightly less than a year earlier, the increase came as a surprise since June 2008 had been the tail end of a massive speculative bubble while much of the world remained in recession in mid 2009.
Analytically, we now face an important question, namely, whether the role of the index funds has permanently changed the price determination process in these markets or whether the level of ongoing interest will ebb and flow with changing market conditions, leaving no net effect on prices in its wake.
The answer to this question has some important implications for the macroeconomic well-being of a commodity producing economy like Australia as well as for the price outcomes in specific commodity markets.
If index funds have changed the market dynamic, they might be a force for higher prices from time to time. However, at other times, their influence could be reversed without regard to underlying market conditions.
The volume of copper contracts controlled by index funds doubled over the six months to June 2009 and increased by 2½ times from the end of December 2007. The number of oil contracts jumped by 21% in the December quarter of 2008, by another 19% in the March quarter and by another 5% in the latest June quarter.
What would happen to the prices of these commodities, for example, if that flow of funds momentum was no longer present and the individual commodity markets reflected a more traditional set of influences?
The CFTC data on index fund activity in the futures markets is released quarterly. The last data release, relating to the June quarter, occurred in July. The next release of data should happen within the coming two weeks and will be worth following to gauge how much these markets continue to be influenced by the index funds.
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