Saturday, May 20, 2006

Warning on market risks as prices fall

Warning on market risks as prices fall
By Kevin Morrison, Gillian Tett and Philip Coggan in London
Published: May 19 2006 20:29 | Last updated: May 19 2006 21:56. Copyright by The Financial Times

A turbulent week in the financial markets ended on Friday with sharp falls in gold, oil and copper prices and warnings from central bankers and Wall Street strategists that investors are misreading the risks.

Paul Tucker, director of markets at the Bank of England, on Friday said the recent climate of ultra-low interest rates and low volatility might have prompted investors to become complacent about underlying risks in the financial market. In particular, an explosion in the use of structured financial products, such as credit derivatives, might have distorted market interest rates – and left investors mis-pricing risk, he said.

Commodities were the latest victims of the turmoil on Friday, prompting two of Wall Street’s leading strategists to warn that prices were highly speculative.

The US benchmark oil price fell more than $1 to $68.35 a barrel and has now fallen 9 per cent from its record high, reached more than three weeks ago. Copper fell about 5 per cent to $7,700 a tonne on Friday and gold dropped 4 per cent to $652 a troy ounce. Even US corn prices, which have risen strongly this year, fell about 3 per cent.

The broad decline in commodities points to selling from index funds, which have been a popular route into the market for investors.

“There has been a sell-off across the board, which suggests that it is commodity index fund selling as they may be facing withdrawals,” said Jeremy Goldwyn, head of industrial commodities at Sucden, the commodities broker.

Institutions have been persuaded that commodities are a useful source of diversification from their traditional bond and equity holdings. A key part of the argument has been their ability to earn a separate return, known as the roll yield, that flows from futures prices being lower than the prevailing, or spot, price. But so much money has flowed into the commodities market that, in many cases, the roll yield has disappeared.

About $90bn of funds track commodity indices, a sixfold increase in the past four years. Now that commodity prices are falling, some investors may be abandoning their positions, although one Goldman Sachs executive said “on balance, we are still seeing net inflows into funds following the indices”.

Stephen Roach, the chief economist at Morgan Stanley, said this week that the commodities market had become the latest in a series of bubbles. “It too will burst, the only question is when.” And Richard Bernstein, US strategist for Merrill Lynch, said there was a 50 per cent speculative premium in commodity markets at the end of April.

Friday’s falls come at the end of a torrid week for financial markets, with equity indices and emerging markets suffering falls.

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