22 May 2006

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The non-ferrous metals markets had Charles Dickens turning in his grave over the past three years since it was the best of times and it was the best of times. Since January 1, 2003, copper rose by 461% when it hit its peak of $ 8750 on May 12 this year. Zinc was not far behind, up 415% (at a peak of $ 3,900), while nickel and aluminum provided good but not grotesquely excellent returns at 204% and 146%, respectively.

But, clearly, it was copper that was the prime mover of this amazing rally, which really put on steam since March this year, with 45% of the three-year price change coming in less than three months. Zinc and aluminum followed copper's lead, surging superbly at the end, but nickel, which has always been something of a weirdo, seemed to dance to its own tune.

The chart shows the price movements of copper and nickel since 2003. The nickel graph bounces around like commodity prices are expected to - in general, commodity prices are much more volatile than those of financial assets since commodities are finite and discrete in supply and have finite and discrete applications. And, indeed, nickel has always been very volatile - its long-term average volatility is near 40%, much more so than the other non-ferrous metals, where the historic average volatility is in the range of 20-22%.

However, in the current run-up, something strange has happened. The volatility of copper has oftentimes risen higher than that of nickel, and currently, at 40%, is more than 5% higher than the volatility of nickel. In fact, since May 2003, copper has been more volatile than nickel as much as 16% of the time. This is clearly very strange, since historically, copper was substantially less volatile than nickel. Volatility - particularly commodity volatility - is a fundamental characteristic of the asset type, and if it changes substantively it can only mean (a) the nature of the asset has changed, (b) all volatilities have changed as a result of some fundamental change in risk appetites, or (c) something strange is going on.

Well, I don't know how many people believe that the nature of copper has changed - I don't. But, both (b) and (c), above seem to fit the reality.

Let us begin with (c) - something strange is going on. Another fundamental of commodity markets is that the forward prices are generally higher than cash prices; this reflects the cost of carry - storing the grain or copper or whatever in a warehouse and financing it. From time to time, the forward market does dip into "backwardation" but this is usually a short-term phenomenon caused by some temporary tightness in supply or large cash deliveries that have to be made. What is strange is that the copper market has been in backwardation more or less continuously since February 2004 - that's more than 2 years!

When it began, there was some talk that some Chinese traders were short and were buying cash (and selling 3 months) to roll over their risk. This talk continued for some time and was doubtless true - where there's smoke there's fire and the copper market is very small so everybody knows when someone is squeezed. Interestingly, all talk of the Chinese squeeze has long disappeared from the market, and the backwardation has finally turned around just as cash prices started their rocket move (over the past couple of months).

This two-year technical carnival has, of course, been put on steroids by (b) - all volatilities have changed as a result of a fundamental change in risk appetites. Over the past decade or so, Alan Greenspan, as chairman of the Fed, which remains the key driver of monetary policy (and financial markets) in the world, changed the nature of the relationship of regulators with financial markets. Rather than trying to push them around (a hold-over from the Breton Woods era) or trying to surprise them (during and after the Plaza Accord), Greenspan, consciously or otherwise, developed a far better - to my mind - way of managing markets: he romanced them.

Of course, this required a fundamental change in mindset, a recognition that speculation, far from destabilizing markets, actually improves market performance by increasing liquidity and, yes, reducing risk. Perhaps the fact that Greenspan took the high chair in 1987, just as Black Monday took charge - this doubtless was a significant force in coloring his understanding of the markets. I believe that Greenspan's greatest legacy was changing the way regulators approached the market. And it was this new "romance" - where the market always (or certainly most of the time) knew what the Fed was thinking - that was responsible for the dramatically lower volatility that has prevailed in virtually all financial asset prices over the past few years. This lower volatility enabled enhanced risk appetites (lower volatility means lower risk), which, in turn, led to the huge run-up in asset prices that we have all been enjoying.

Thus, copper at $ 8,000 a tonne is the result of specific technical contortions turbocharged by the huge risk-taking bubble that was created by the "Greenspan effect". Sure, there has been a substantial increase in demand from China and other animals. But increased demand can push prices up by 20%, 30% even 50%, but it can't push volatilities to the stratosphere and it can't double prices in a few months.

The tremors we felt last week, when copper fell by 5%, triggering "corrections" in a swathe of markets across the globe, were merely the start. With uncertainty in global markets already higher as a result of Bernancke's inexperience, it is clear that the Greenspan premium will be unwound, probably in fits and starts over the next few weeks. How hard this will affect different markets depends on many things - fundamentals of supply and demand, the amount of speculative froth and, of course, how much longer the Fed raises rates.

My sense is that copper above $ 5,000 or $ 5,500 is much too high; another (?) investment guru, Marc Faber, feels that some markets could correct by as much as 30%, which puts copper just about at these levels. Nickel, on the other hand, may not fall as much. The historic ratio of nickel to copper prices of around 5; a $ 5,000 copper price would - in historic circumstances - suggest a nickel price of around $ 25,000 - higher than it is today. While I would be very wary about going long nickel - or anything, for that matter - at this time, the buy Ni vols/sell Cu vols remains an attractive play at this time.
Returning to Mr. Dickens, I hope we don't have to go through too long a period of "it was the worst of times, it was the worst of times" before we return to normal - i.e., it was the best of times, it was the worst of times.

Amen.

Currency Markets - Rupee and Majors

USD/INR

Fortnightly movement: O-44.8300 H-45.6400 L-44.8175 C-45.5575
Sentiment: Depreciation to Continue, fall in stocks may aggravate the pace
Expected range for 1 Month: 45.00-46.00
Expected range for 3 Months: 44.75-46.00

The bears yet again managed to rule over the bulls as the domestic unit depreciated at a quick pace. The rupee lost 72 paise over this fortnight primarily due to net sales by FIIs following a steep fall in the stock indices. The offshore arbitrage also added to the fall in the domestic unit. Major fall came during the later end of the fortnight where the fall in the global commodity prices triggered fall in all major stock indices. Fall in stock prices by a large extent caused various stop losses to hit and caused rupee to depreciate to a large extent. The central bank maintained its presence by absorbing FII flows and supported Rupee to remain below 46 levels. The forex reserve continued to rise to USD 162 bn. by last week end.. The 6-month benchmark forward premium, which stood around 1.32% last fortnight, closed at 0.9% this weekend.

With fears of falling stocks to continue and weakness in the global metal markets, one should not be surprised to see continuedweakness in the domestic unit. Also the expected likely strength in the dollar may cause rupee to inch towards a level of 46.00.

EUR

Fortnightly movement: O-1.2740 H- 1.2970 L-1.2661 C-1.2763
Sentiment - slightly negative
Expected range for 1 Month: 1.2500 -1.3000
Expected range for 3 Months: 1.2300 - 1.3000

As anticipated, the Euro not only reached but also exceeded the 1.29 target and that too within just a week ignoring a much lower-than-expected US trade deficit. Tthe Euro and other majorscapitalized on reports of China planning to quadruple its gold reserves and some worse-than-expected US data relating to retail sales and consumer sentiment. However, the Euro received a setback and fell over 2 cents from the high of 1.2970 following a sell-off in gold, oil and other commodities as also a shift in rate expectations following a stronger than expected rise in US core CPI last Thursday and hawkish comments from Fed officials last Friday.

The Euro’s medium-term downtrend may have possibly resumed with a 12-month target around 1.10! However, a confirmation may come only from a decisive fall below 1.23. Till then there could be sideways trading with those who missed much of the last rally trying to join the bull camp in the 1.25-1.23 area. This medium-term Euro bearish view will likely be aborted only in the event of a decisive rally over 1.30

GBP

Fortnightly movement: O-1.8622 H- 1.9023 L-1.8513 C-1.8776
Sentiment: slightly negative
Expected range for 1 Month: 1.8300 -1.9000
Expected range for 3 Months: 1.8000 - 1.9000

Again, Sterling outperformed the euro thanks to upbeat UK manufacturing and industrial production data. With a split vote at this month's MPC meeting the interest rate outlook remained neutral.

Sterling's medium-term downtrend may well have begun with a 12-month target of around 1.65. Confirmation of the same may, however, require a sustained decline below 1.80 while a decisive rally over 1.90 may probably abort this bearish view.

JPY

Fortnightly movement: O-112.09 H- 112.20 L-108.93 C-111.66
Sentiment: slightly negative
Expected range for 1 Month: 109.00 - 113.50
Expected range for 3 Months: 106.50 - 115.50

The yen soared against the dollar on i) Bank of Japan Governor's comment that the Japanese central bank was open to the timing of a hike in interest rates; and ii) the report of China planning to quadruple its gold reserves. The dollar tumbled as low as 108.93 yen before rebounding sharply after US core CPI data, hawkish comments from Fed officials and relatively dovish comments from the BoJ Governor that there was no discussion at last week's policy-setting meeting on a specific timing for ending the zero-rate policy.

The dollar is likely to rise against the yen to 125 plus in a year's time but the downside could first extend to 106.50 or so depending on the timing and extent of a yuan revaluation. However, a sustained fall below 106.50 yen aborts the dollar bullish view.

Dr Risk's Prescription

Has the dollar resumed its medium-term uptrend?

A fortnight ago we had said, inter alia, that the market could again get hawkish about Fed policy in 4 to 6 weeks, if not earlier and that in the meantime, the Euro may rise to 1.29; Sterling may rally to 1.89 while dollar/yen could fall to about 109 before the dollar's medium-term uptrend resumes. The targets for Euro, Sterling and Yen were exceeded in just one week before a sharp dollar rebound. The Euro rose to about 1.2970 and Sterling to 1.9020 before finishing last Friday sharply lower at about 1.2765 and 1.8765 respectively. Likewise, dollar/yen fell to about 108.90 before rebounding to finish last week at about 111.65. While US economic data last fortnight was mixed, the dollar's sharp rebound appears to have been triggered by last Wednesday's report of stronger-than-expected rise in US core CPI, hawkish comments from Fed officials a day later and a sharp setback in commodity prices last week. So has the dollar's medium-term uptrend resumed?

With oil and other commodity prices still very high despite last week's sharp setback, inflationary pressures are unlikely to subside quickly. We may see some more Fed rate hikes in the second half of 2006 and whereby the dollar's interest advantage over the Euro may continue, or even widen.

From April 17 to May 17, with Euro rallying from 1.2130 to 1.2970 with Sterling and Yen keeping company, It is not unreasonable to expect an equally sharp correction till end May/early June. A decline in the Euro to 1.25 and in Sterling to say 1.83 could well be considered as a correction from a technical perspective.

If on the otherhand, Dollar continues to rise breaking 1.23 against Euro, we may even see Euro falling to 1.10 in the next 12 months! This dollar bullish view will be aborted if the Euro rises decisively over 1.30, Sterling over 1.90 and dollar/yen falls below 106.50.