We Are Living In A Powerkeg and Copper Is Giving Off Sparks

I've seen some articles outright pooh-pooh the drop in copper or couch it in a positive light, or "this could be really bad, but not yet." While I don't think it is a Bear Stearns moment, it may be like the auction rate security problems a couple months earlier because of copper's role in the Chinese financial system. The copper market is a microcosm of the past 5 years of government intervention and asset bull markets. Money creation (in China via credit, in the U.S. via base money) fueled an artificial rise in asset prices.

Copper has a Phd in economics for a reason: it is a crucial industrial metal. Economic booms and busts begin at the higher stages of production (such as manufacturing) and filter their way down to the consumer. Oil is also an important component in the global economy, but millions of consumers don't put copper into their cars each day. When demand for copper rises or falls, it's a good signal of future growth because demand mainly comes from the higher (earlier) stages of production.

Copper prices have taken a pounding in recent days, starting on Friday March 7. The losses on a percentage basis are not huge except for the fact that they happened in 3 trading days. If prices bottomed and rebounded from here, this is a false alarm. However, copper also blew through major support at $3 and it continues to weaken as of this writing. The next potential support level is $2.75; then it's on to $2. So this isn't just a big sell-off, but a big sell-off that shifted the technical picture. Until copper bounces above $3 and stays there, I'm going to be hearing alarm bells.

Why did it drop? Supposedly, the small bond default in China was the trigger and maybe it was, but it really doesn't matter. That default was a grain of sand on China's debt pile. Many analysts and investors have been waiting for this moment because of China's use of copper and other industrial metals as collateral for loans on top of the already huge demand from infrastructure developments, itself fueled by the credit bubble. Copper demand is leveraged on Chinese growth. Chinese infrastructure development demands copper; the credit system demands copper; the Chinese government invests in commodity production in places such as Africa. That demand fuels growth in emerging markets which comes back to China as export growth and more forex reserves, which are used to expand the credit bubble.

The drop in copper is a signal that the cycle is breaking down. It could also be the cause of a breakdown because copper is used as collateral. Either way, the drop is very serious because it is sending up a huge warning flag that there is a major shift in trend away from growth in China. Without Chinese growth, emerging markets slow further and the global economy goes into recession.

Stories such as the one below also suggest that a bearish interpretation is warranted.

U.S. scrap copper trade fears defaults from China

At least one U.S. scrap copper trader has suffered "large" losses after a buyer in China defaulted on a deal in the past week, one of the first signs that sinking prices and tightening credit are taking a toll on the physical market.

The customer walked away from a deal that had been guaranteed by a letter of credit, said a market participant who was familiar with the matter, but withheld the identity of the companies involved to protect business relationships. China is the world's biggest copper consumer.

Other traders in the U.S. scrap market said they had heard of similar defaults starting to crop up as a rout in copper prices prompts Chinese buyers to shred contracts with U.S. suppliers, reviving memories of the wave of defaults that shattered trust in the market after the 2008 financial crisis.

Optimists will say the drop in copper is isolated; it's not a clean signal due to Chinese debt. Au contraire, it is an even better signal because Chinese debt fuels Chinese growth. A bit more sensitive, but still a good signal. There is no way to downplay the drop in copper. As I said, if prices rebound, then this is a false alarm. But if copper continues to drop or cannot recover, this is a warning for the global economy and global asset markets.

Spot Copper Plunges Through $3

Here we go. If this is a real break, the next support is at $2.75. The stock market, as of this moment, remains oblivious.

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......

Buy puts on the yuan?

From John Mauldin's Thoughts From the Frontline: Changing the rules in the Middle of the Game

“We saw today that 80% of Chinese construction firms say developers are now behind on payments (late cash flow), and that consequently land purchases are already 42% down y/y (slowing local authority cash flow). We also heard that pricing controls means that utility companies no longer have the cash flow to afford vital imports. Q3 corporate cash flow was down 27%.

“China's trade surplus is annualizing this year at USD152bn, FDI [Foreign Direct Investing] @ USD114bn yet its FX reserve increase is USD472bn. The attached chart [below] shows Chinese external borrowings which unfortunately were last updated at the end of last year, but the data would infer these have continued to soar.

“I am being told that European banks are now starting to shrink their foreign loan books to meet domestic needs, with Mexico, Brazil and China all big losers. With China now saying they may run a full-year trade deficit next year, and with them unable to afford to import vital coal and other resources without either suffering domestic inflation or without selling its FX reserves, it may now well be time to consider some sort of puts on the yuan. In fact the only reason perhaps not to is that India may collapse first, reducing the competition for coal and giving China a little more breathing room.

Using a fund such as ProShares Ultra Short China (FXP) may be the best route for retail investors to directly short a decline in the renminbi, although there will be numerous knock-on effects and funds such as PowerShares DB Base Metals Double Short ETN (BOM) should also do well. Direxion Daily Emrg Mkts Bear 3X Shares (EDZ) would also likely be a winner.

I haven't discussed my Marketocracy portfolios in awhile, but I have these types of ETFs in my China fund, which is up about 2% this year. The gains were mainly from a large gold position, which was the largest holding; it's now a very small position. The aim of the fund is to be a play on China, holding either Chinese stocks (always some), but also commodities and currencies related to China. Chinese are heavy gold buyers, hence the gold position. Europe is the largest export market, so ProShares UltraShort Euro (EUO) or PowerShares DB U.S. Dollar Index Bullish Fund (UUP) get added during crisis periods. The largest position is currently FXP, with short funds totaling about 33% of assets, which works out to effectively 70% short exposure based on leverage. Cash is near the mutual fund regulated limit of 35%, with short term bonds upping that to about 40%. My timing has been bad with the short funds, but I'm still of a mind to increase short positions if the market rallies. If timing remains an issue, I'll just move to cash equivalent assets and ETFs such as UUP to ride out the storm.