Dr.Copper is down for the three straight weeks after trading up to four-year highs, providing cover for the bullish global reflation bet.
As we noted previously, there’s just one little problem with all this copper-futures-price-based exuberance and extrapolation.
The one thing that’s missing is buyers of the actual metal.
As Bloomberg reports, evidence of the anomaly can be seen in the premiums that purchasers of physical copper pay over futures prices to cover shipping and other costs.
Typically these rise as demand grows and buyers are willing to pay extra to access supply that’s being used up at a quicker rate.
Yet, even with factories running at the fastest in years, premiums have been stuck at a low level.
That’s a disconnect with the optimism in futures markets, where hedge funds have been adding to their bullish bets since the middle of December.
But as hedgies have been piling long into futures, the options markets are suggesting resurgent Dr.Copper is about to relapse…
If one looks at the price of copper (Figure 1) and the implied volatility on its options (Figure 2), one might think that the metal – often referred to as Dr. Copper for its reputation as a leading prognosticator of economic health because of its widespread applications — has returned to robust health after a bad spell from 2011 to 2015. Recently, the price has been soaring, and the implied volatility low. Fundamentally, copper looks good. The global economy is expanding robustly and growth in China, copper’s single-most important market, stopped slowing two years ago. A peek below the surface, however, shows that traders have concerns that this benign situation may not last, and 2018 could prove those concerns to be valid.
A deeper look at the copper options market, however, shows a high degree of downside skewness as one moves away from at-the-money (ATM) options. Out-of-the-money (OTM) put options on copper command much higher implied volatility premiums than similar OTM call options (Figure 3). Moreover, in Q4 2017, copper’s implied volatility rose relative to its Q3 levels while implied volatility on options fell sharply for most other futures contracts (Figure 4).
What is the downside risk that copper traders are so worried about? We think it can be summed up in two words: China and equities. China’s economic stabilization in 2016 and 2017 after years of slowing growth was an unexpected and beneficial surprise for copper producers (Figure 5).
Rather than cratering as many feared that it would in 2015, China’s growth rate improved in 2016 and 2017 as the Xi Jinping Administration stimulated the economy ahead of his successful bid to secure a second mandate. Now, with the mandate in hand, the risk is that China’s economy will begin to slow under the pressure of a mountain of debt (Figure 6), a crackdown on lending growth and a broadening of the focus to include environmental concerns at the possible expense of growth.
If China’s growth slows in 2018, as its yield curve suggests (Figures 7 and 8), copper prices have the potential to fall a long way, perhaps even retesting or breaking through their 2015 and 2016 lows.
Equity markets pose another risk. For the moment, global equity markets remain robust. Some of the markets, however, have become quite pricey and as the world economy moves into a more advanced stage of recovery, the easy monetary policy that has supported the markets will probably come to an end. (See our papers on the VIX-Yield Curve, Credit Spread-Yield Curve and Unemployment-Yield Curve).
That said, late stage equity bull markets can be quite powerful. Stocks soared in 1988 and 1989, at end of the 1980s expansion. They did they did even better during the late 1990s and also did well in the later stages of the 2003-2007 expansion. As such, equities could continue to pull copper prices higher despite somewhat stretched valuation levels.
The good news for investors who might be concerned about how copper will perform in the event of an equity bear market is that the day-to-day correlation between copper and equity prices has been relatively low for the past few years; and were also not too high during the bear markets from 2000 to 2002 and 2007 to 2009. (Figure 9). As such, even if U.S. equities sell off, they might not, to a large extent, negatively influence copper prices. That said, if stocks continue to rally, they might also not be particularly supportive, especially if copper looks more to China than to the U.S. and Europe as a source of price support.
If copper does sell off, watch for currencies such as the Australian dollar, the Brazilian real and the Chilean peso which in the past have correlated highly with copper, to find themselves under downward pressure. Weaker emerging market currencies could also increase the downward pressure on China’s forex reserves and could eventually spark a devaluation of the renminbi. This wouldn’t be due to lower copper prices but rather to lower Chinese economic growth which could send commodity prices downward and put emerging market currencies under pressure.
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Copper prices and ATM options prices behave as if the global economy will continue to perform well.
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The skew on options betrays nervousness about downside potential in copper.
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If China slows in response to monetary tightening and high debt levels, copper prices could come under downward pressure.
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Equities pose some risk to copper but they aren’t always as highly correlated as one might expect.
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