The mad, bad commodity rally

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There’s something wrong with this rally.

To be honest, beyond some vague notion of Japanese reconstruction demand, I can’t find any real cause for it. With China clearly not done with tightening, QE2 about to cease, the ECB hiking rates, global growth past its prime and oil punching through $1.10 on Gaddafi’s scorched earth policy, we’re due for a whack.

All of these are macroeconomic markers, but the liquidity issue must feed into trading fundamentals somewhere. In my view it’s commodities.

First, let’s look at Chinese demand in copper and iron ore. The FT has an instructive piece:

Is Chinese copper demand faltering? For the hundreds of miners, smelters, fabricators, bankers and hedge fund managers gathered this week for the industry’s big annual conference in Santiago, that is a market-moving question.

After an impressive bull run that has taken copper to all-time highs of more than $10,000 a tonne, inventories of the red metal are piling up in Chinese warehouses.

Prices have fallen 5 per cent from their peak in February. The issue is whether the world’s most voracious copper consumer has been using less copper, or whether smelters and manufacturers further down the supply chain have been running down stocks in the hope of lower prices.

The issue is of critical importance to the copper market. China, which eats up 40 per cent of global supplies, is the single most important driver of prices.

Apart from macroeconomic shocks such as a sharp jump in oil prices or a worsening of the eurozone debt crisis, no other question has more impact on the market.

If, as some suspect, the build-up of Chinese copper stocks represents a genuine slowdown of demand for the metal, the market may also be transmitting a broader message about the state of the Chinese economy: that the government’s measures to slow growth are working.

In the Chilean capital, at this week’s Cesco conference, many in the industry were confused about the short-term outlook for copper.

Nobody disagrees there has been a sharp rise in warehouse stocks in and around China. There are no official statistics, but traders estimate inventories of copper in bonded warehouses at ports – where it can be held before import duties are paid – doubled in the last six months to about 700,000 tonnes.

From Metal Prices, here are the graphs for copper inventory on the LME, Comex and Shanghai:

That looks like pretty much one way traffic to me for the past three months: rising stocks.

Let’s look at iron ore too. The current rally began in July 2010 when the Indian state of Karnataka banned ore exports. Here’s the one year ore chart:

The rally started a week or two prior to the ban but you’d be hard pressed to argue it hasn’t played a major role in keeping speculation roaring on the resulting supply shortage story. As you can see, the rally then went parabolic in November or thereabouts on the massive Chinese build-up of iron ore inventory in ports:

How much higher do you think these stocks can go as China slows? Do you want to guess?

Next, let’s look at the effects of QE2 on commodities. Here’s a chart of the CRB (commodity) index:

I mean , holy cow, let’s not look past the obvious. That is a QE2 afterburner rally since late 2010. And to make the point about how overstretched it is, let’s turn to a nice graph from Research Puzzle:

A major divergence between commodity and equities markets. Admittedly, it’s been wider, but only once. Check out too the 120 day correlation block for commodities.

On top of that, as we all know, the Australian dollar has decoupled completely from sense and is running wild and free in Elysian Fields. Data Diary has an excellent post on just how overstretched it has become. It includes this terrific graph on CME leveraged longs:

I’m obviously tempted to call an end to the whole box and dice. But I’m not going to. These kinds of tearaway speculative rallies can go on and on as money chases money and everything keeps going higher because its going higher. I can only note that three fundamental drivers are eroding: China is tightening, QE2 is ending and oil is entering dangerously high territory.

However, there is one more graph to show that suggests it ain’t over yet by a long shot. From Alphaville:

The dark line is the degree to which the Fed has diverged from the Taylor Rule. As you can see, the more it does so, the higher gold (and other commodities) track. Even when QE2 finishes, we will be so far from Taylor Rule monetary settings that it is laughable. Plenty of juice left in the tank.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.