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Silver proves financialization of commodities, dominates market in past week.

Before this past week, the <a href="">COT report</a> and the <a href="">high correlation among unrelated commodities</a> already point to the financialization of commodities as a financial asset class.

In this past week, the plunge of commodities further proves this point.

On Monday, silver began to plunge because the Commodity Exchange raised the margin requirement for silver the previous Friday.<span style="mso-spacerun: yes;">&nbsp; </span>On Tuesday, it fell again after another margin requirement hike.

What these hikes do is take away liquidity.<span style="mso-spacerun: yes;">&nbsp; </span>It's like the Federal Reserve raising interest rates and making the cost of borrowing higher &ndash; but only within the silver market instead of in the broad economy.

As liquidity became scarce in the silver market, traders sold positions to raise cash.<span style="mso-spacerun: yes;">&nbsp; </span>This started a cycle of lower silver prices, margin calls (i.e. the exchange demanding cash from traders), selling silver to meet the margins calls, which leads to even lower silver prices.

This cycle also confirms that silver's astronomical rise prior to last week was highly-levered, meaning speculators who bought silver borrowed heavily to do so.

As silver plunged by as much as 30 percent this past week, traders also began to liquidate positions in other commodities to raise cash.<span style="mso-spacerun: yes;">&nbsp; </span>The same cycle &ndash; albeit less pronounced &ndash; thus took place in these other commodities markets.

The drop in commodities across the board boosted the US dollar, hurt higher-yielding currencies (especially ones linked to commodities), and pushed down equities.<span style="mso-spacerun: yes;">&nbsp; </span>Silver's margin requirement hike, therefore, dominated the broad global markets this past week.

What happened was essentially a smaller version of the 2008 financial crisis, during which illiquid and decaying mortgage-backed securities ripple through the broad markets and caused a massive flight to liquidity &ndash; giving a huge boost to the US dollar and Treasuries while everything else declined in value.

So how can traders adjust to this environment of financialized commodities and high leverage across financial securities?

One, be aware of the powerful influence of correlation and don't stubbornly buck the trend because of some market-specific analysis.

Two, assume momentum and self-reinforcing cycles (at least in the short-term) for large market moves, especially ones to the downside.

Three, realize it's speculators who are dominating the market, so if fundamentals ever disagree with market action, be willing to ignore fundamentals.

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Publication:International Business Times - US ed.
Date:May 6, 2011
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