The mad, bad commodity rally

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.

Houses and Holes


  1. As I said yesterday, I think its all speculative. The Japan/Libya crisis was the test the market was waiting for, and once the market decided it was a non-event everyone has been chasing the rally higher.

    I agree these things can run for years longer than any rational person would believe — look at Nasdaq in the late 90s. The difference is a commodities bubble is far more damaging than a stock market bubble, 2008 showed us that. Food riots can’t be too far away.

    For the Australian economy it sends a (possibly false) price signal that drives investment in mining, and crushes the non-resource tradeables sector. The domestic economy just gets higher-than-necessary interest rates.

    What if the Great Aussie Resource Boom was the greatest market failure since climate change?

  2. Consider this as an angle, too…

    Assuming the Aussie housing market tanks this year ( as I think it will), and the RBA starts to drop rates to stimulate, then consider all that hot AUD forex money selling off, and flowing, well, where?

    I’d figure a lot of it into commodities? I mean, other that precious metals and a few stocks, what is left that is worth it, comparatively?

    I’d agree that commodities still have a lot of gas in them, but that they have a way to fall, ultimately.

    My 2c

    • If the Aussie housing market slows further, Glenn has more than 400 basis points of ammunition to revive it, and keep it where he wants it — stagnant.

      I doubt he’d need to cut much to achieve that, so panic selling of AUD is pretty unlikely. The interest rate differential between Australia and anywhere else is still huge, and as long as the China growth story is in place, the Aussie will remain strong.

      • Hopefully if he cuts the interest rate the dollar will drop and inflation due to the cost of imported goods will spike putting pressure on him to raise the rate again. I certainly do not want it to drop to much or I will be getting a negative rate of return on my term deposit once tax and inflation is taken into account.

        • Local food will spike (transport costs – Diesel) and the boganistas will be crying blood at the local Mobil filling the SUV. Armed guards at servos?

  3. Commodoties are the place to be as long as Helicopter Ben is at the helm. The world goes to hell and these fools all over the world have shown their reaction is to print money = commodities go up.

    The USA economy recovers (inflation probably kicks in) as does the global economy and China and India want more resources = commodities go up.

    That’s not to say it won’t all end in tears…..eventually. At these levels you would expect massive volatility in some commodity prices in the later half of this year and 2012….just my opinion.

    • Except China uses most of the resources it buys from Australia to build things, not make things for export. This is especially true of iron ore, and most of the post-GFC growth in our resources exports has been iron ore going to China.

      We are now highly leveraged to the Chinese construction boom. A rebound in the US economy will go nowhere near making up for a crash in Chinese construction.

      • oh i agree……that’s the end in tears part. Anyway prices will fall in the next few years as new supply comes on board. New supply in commodoties always lags the demand (quite obviously) and generally by the time it’s online there is no longer a need for it, so you get a glut of supply pushing prices down.

        • Yes and no. You have to look past the short term noise to see what is happening with each commodity. In the medium term copper should hold up as supply is predicted to be constrained. Coal should also hold up based on growing demand from India. Iron I don’t know much about, although there is talk of supply coming from west Africa by 2015.

  4. Crocodile Chuck

    Hasn’t QE 3 already happened with the flood of liquidity a few weeks ago by the Japanese CB to bring down the value of the yen?

  5. Copper: This is interesting for background:
    Pretty sure in 2009 Chinese inventories were estimated 1.2m t – now estimated 700,000t. Some analysts are claiming a deficit of some 600,000t! Wait and see.

    Iron ore, would have guessed close to peak, increased production coming on line from more diversified sources – plateau then decline…but the QE’s have changed the game. I have no clue!

  6. The massive selloff was a liquidity event and once that subsided it should’ve been no surprise that a bounceback rally was on the cards.

    We are simply back to where we were in early March plus a little extra. Saying that I really don’t think we can punch through 5,000 with much conviction due to the issues you’ve mentioned. If some of those issues subside we will smash through 5,000

  7. the cause 4 it? many nations have been stock piling commods and shifting into hard assets while the winners wait for QE to end and they are eating from the trash.

  8. crocodile chuk has some idea…..its hyper inflation bitchezz save your paper money with ink on it, let us know how you end up in a couple years.

    Whoever thinks money printing will end doesnt understand the credit money system/