2014-03-12

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.

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