The Copper Yuan Carry Trade
Copper fell more than 3% on Wednesday, April 4, its most in nearly two months after the latest meeting minutes from the U.S. Federal Reserve meeting showed policymakers seem not quite ready to launch further economic stimulus. The red metal did manage to rebound a bit to $3.79 per pound on Friday after the BLS reports showing an improving labor market, and on hopes that China may loosen its monetary policy to avoid a hard landing.
Prices of copper have slid about 5% since hitting their highest levels in nearly five months at $3.9950 per lb in February. China, the biggest copper consumer in the world., reported strong copper and copper product imports in February to 484,569 tons, up 17% over January and imports in the first two months this year were 50% higher than the same time last year (see chart below).
However, rather than a sign of strong end user demand, a lot of the stockpile copper will never get shipped out to end-users because they were bought for speculative reasons. Traders are using copper as collateral for other investments - offshore yuan forwards and interest rate differentials seems to be the most popular trade right now.
"Before a selloff in the offshore markets in September, trading firms were using copper to fund a carry trade, where they secured LCs in low-yielding dollars to fund plays in the spread between onshore and offshore yuan, layering an element of FX gains on top of commodity price gains.
They could also speculate on the currency by using yuan non-deliverable forwards, which are contracts betting on the yuan's direction but settled in U.S. dollars.
The premium for the offshore market has climbed as high as 3% over the onshore rate last year due to limited supply and high demand for exposure to the Chinese currency, whose trade is limited outside the mainland."
According to Reuters, the offshore market, or CNH (Chinese yuan traded in Hong Kong), is largely the result of China's experiment to promote its currency's use in international trade and has traditionally traded at a higher value in dollar terms than the mainland yuan.
The premium for the offshore market has climbed as high as 3% over the onshore rate last year. Local traders estimate some 80-90% of the bonded copper stocks in Shanghai belong to trading houses using imports as a way to get cheaper financing.
This type of financing deals draws world's copper stocks into China depressing local prices, tightening supply outside of China, while distorting other supply, demand and price indicators such as imports data and reported stock levels.
Various projections point to a world copper production deficit of about 250,000 metric tons in 2012 as supply growth continues to lag behind demand growth, and supply and demand is expected to reach balance by 2013. However, analysts estimate that more than 1 million tonnes of mostly unreported commercial stocks of refined copper cathode are currently sitting in warehouses, the highest level since 2009. That's about 4 times of the expected deficit this year, which suggests the current copper market seems more than balanced than most people believe given the slowdown in China's economy.
For now, traders are still bullish on copper as Managed money funds increased their net long position on copper futures and options by 25% in the week ended April 3, according to the data from the CFTC (see chart below).
In the long run, copper price outlook is positive just on rising mining costs, diminishing resource base, and the demand growth expectation. But don't expect copper to break out unless there's a real pickup in consumption, and Chinese players start offloading the surplus stockpile.
From a technical standpoint (see chart above), copper's been trading in the $3.70 to $3.95 per pound range since the start of the year, and should find short-term support at $3.70, with major support at $3.30, major resistance at $4.00. So if you are shorting copper, put the stop at $3.70, but start the long position (with a stop at $4.00) if copper breaks the $4 resistance.
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