Buyers withdrew more copper from the London Metal Exchange’s global warehouse network on Wednesday than at any time since daily records began in 1996, extending a 19-day drop.
As Bloomberg notes, while the net decline in percentage terms was also the biggest since the height of China’s raw-materials boom in 2006, some have warned against reading such moves as an end to a years-long supply glut. A tug of war between financial traders with opposing views of the market has led to sharp swings in metal moving in and out of storage in the past year.
However, stockpiles also slumped 8.2% on the Shanghai Futures Exchange, which is notable because last year we saw the London and Shanghai inventories see-sawing (up in London, down in Shanghai, and vice versa)…
A question that emerged is what China is spending all this newly created money on. One answer emerged overnight when Bloomberg reported that after tumbling in the first half of 2015, copper inventories at the Shanghai Futures Exchange had been steadily rising, and in the most recent week soared by 11% to an all time high of 305,106 tons.
At the same time reserves at the London Metals Exchange declined for 11 days to the lowest level in more than a year, in other words China is shifting idle inventory from Point A to Point B.
But, this most recent withdrawal surge (the largest in history) suggests a sudden failure of the long-running commodity “collateralization” transaction – or CCFD – regime implemented in China years ago, as described in this post and summarized in the chart below…
Copper, as China pundits may know, is the key shadow interest rate arbitrage tool, through the use of financing deals that use commodities with high value-to-density ratios such as gold, copper, nickel, which in turn are used as collateral against which USD-denominated China-domestic Letters of Credit are pleged, in what can often result in a seemingly infinite rehypothecation loop (see explanation below) between related onshore and offshore entities, allowing loop participants to pick up virtually risk-free arbitrage (i.e., profits), which however boosts China’s FX lending and leads to upward pressure on the CNY.
And sure enough, we have seen USDCNY surging in recent months… (even if the RMB basket against global currencies has stabilized)
An example of a typical, simplified, CCFD
In this section we present an example of how a typical Chinese Copper Financing Deal (CCFD) works, and then discuss how the various parties involved are affected if the deals are forced to unwind. Exhibit 3 is a ‘simplified’ example of a CCFD, including specific reference to how the process places upward pressure on the RMB/USD. We believe this is the predominant structure of CCFDs, with other forms of Chinese copper financing deals much less profitable and likely only a small proportion of total deal volumes.
To summarize, Goldman notes that these shadow banking vehicles – CCFDs – involve a long copper physical positions and a short futures position on the LME.
And so, the current crackdown on leverage in the system by Chinese authorities may be forcing unwinds of the CCFDs – thus putting upward pressure on Copper futures (unwinding short positions) and selling physical copper (which would mean procuring the physical metal before passing it on). These are exactly what we are seeing in the market currently.
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Barclays has also called the copper rally overhyped, while Bank of America Merrill Lynch said it’s the metal most at risk of a reversal, with the optimism of investors in financial futures disconnected from slow conditions in the physical market.
“When you look at the state of the refined copper market, you certainly question why prices have risen so significantly,” Snowdon said by phone from London.
And finally, bear in mind that the lagged response to China’s credit impulse is about to hit base metals…The rise and fall in China’s credit impulse that has been so highly correlated (on a lagged basis) with copper for the last eight years…
However, as one analyst noted,
“Getting short in any base metal is risky right now when you have this broad positive macro theme and increasing investor participation, particularly in China’s onshore market.”
“This is probably one to stand back from and wait for Chinese macro sentiment to turn.”
And finally, bringing the narrative back to American shores, DoubleLine’s Jeff Gundlach tweeted recently about the “Copper/Gold ratio soaring to the high of the year!”…
“Not good news for the “1.50% 10 year” crowd. Neither is 10 year Bund holding above 50 bp.”
If China’s legged credit impulse is about to have its peak effect on Copper (as we showed above) then perhaps, just perhaps, the real pain trade (given the surging shorts in T-Bonds), is a 1.50% 10Y yield after all… driven by a plunge in copper prices.
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