No More Free Money In BOM and BOS

Deutsche Asset & Wealth Management changed the redemption size for their commodity ETNs from 200,000 to 5,000 on Friday.

The big redemption size made these busted ETNs because volume has been too thin to acquire in size. It would take an investor a long time to buy enough shares to force a redemption. On the other side, no one would go out and buy the underlying assets to swap them for an ETF trading at a 20-40% discount.

The funds were attractive to me because I wanted a short bet on industrial metals, willing to work to pick up a position slowly over time and didn't need a large position. The discount was gravy, and I assumed the herd would eventually come back and close the discount gap on top of gains from falling metals prices.

The result of Deutsche's decision was as follows on Monday:

As we can see, it was a smart move by Deutsche, especially with a breakdown in copper and other industrial metals becoming a real possibility. At the very least the change in policy should keep the discount smaller going forward, but volume could stay elevated in the coming days if metals break lower and ETP traders look for a suitable product.

I am still long both BOM and BOS.

Effects of Credit Problems Start to Hit Industrial Metals; Short Metals ETNs Still Trade At Discount

I noticed selling in copper earlier in the afternoon in China, but the selling hasn't let up.

Copper Collapses Most Since Dec 2011 On China Credit Fears

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.

Click through to see a detailed description of how this works. A similar system was used last April with gold when fake exports caused a yuan rally, but that was a short-term phenomena. The copper financing goes back years and is a complex arrangement. It is unknown how much debt is backed by copper, and it is also unknown how many times the same copper has been used to take out loans (rehypothecation). There's enough anecdotal evidence to suggest the debt far exceeds the collateral. Were copper to break $3 and heavy selling to commence, banks may call their loans and find there is no collateral, thus pushing more banks to call their loans. Eventually, what copper there is will come out of financial storage and get dumped on the world market, or at least satisfy Chinese demand internally for some time. Either way, copper could be in for a plunge.

I went short base metals via two ETN products, PowerShares DB Base Metals Double Short (BOM) and the single short product, BOS. The latter fund is very lightly traded and never proved popular with traders. I could only get a very small position, but it traded at a more than 40% discount to NAV, a nice margin of safety. BOM had a smaller, but still significant premium, currently about 17%. BOS is the 20th best performing ETF in 2014 thanks to the discount being cut in half; it's now about a 23% discount. Given the small volume, it doesn't make sense to go with BOS anymore. Even getting shares of BOM at a good price will prove difficult.

That said, there is plenty of evidence that these types of unloved ETNs and ETFs coming to life. Traders ignore them when they're not moving, but if there's a big trend unfolding, I expect volume will pick up enough to close the discount at least partially.

A market of two minds....and can China have a depression?

Here's copper today. First, there's the HSBC China PMI number sending copper lower. And then the rebound and rally higher......

I accept that I could be wrong about a recession or serious financial crisis in China. However, one thing I keep seeing the China bulls say is that there's still a lot of growth left because the Chinese economy is still at a low level of development, especially in the west. Then why did the United States have a Great Depression? Air travel, automobiles, radio, rural electrification......how did a country on the verge of a technological boom suffer a decade of economic depression? As Rothbard shows in America's Great Depression, a credit bubble followed by bad policy can be a witches brew. Most people think China has good policy, but it was government intervention by Hoover, then taken to the fifth power by FDR, that made the depression a decade long affair.

I see a conundrum: if Chinese leaders are truly perspicacious, they will allow a major crisis and aim their policies at accelerating the bottoming and next growth phase. All the Chinese response to 2009 was, was Hoover on nuclear steroids. This has created a bigger problem than existed in 2008, when housing prices fell 30% and the stock market fell 80%. Chinese real estate prices are at record highs and still climbing about 7-10% per annum. The yuan is about 10% higher versus the U.S. in a period when most of the world was devaluing their currencies against the U.S. dollar, which is up from its 2008 lows. And yet, stock prices are less then 20% above their 2008 low and still down 66% from their 2007 peak.

I put my money where my mouth is: I own shares of PowerShares DB Base Metals Double Short ETN (BOM) and PowerShares DB Base Metals Short ETN (BOS). BOS is extremely thinly traded, but sells at a 22% discount to NAV, and sometimes more or less during the trading day. It is very hard to obtain shares because of the thin trading, but I'm betting it will be heavily traded when China sinks into recession, delivering a gain on NAV, plus close the 22% discount. I also have puts on Freeport McMoran (FCX), and will consider adding to these positions or opening new positions as conditions and opportunities warrant. Still looking for out of the money yuan puts......