Note that prior periods of USD strength have taken the wind out of gold’s uptrend. With the 150 day moving average and the long term uptrend sharing the $1600 that area looks like the most probable target for this consolidation.

But the recent ructions in global markets are threatening to derail these broadly held beliefs. Following is a chart of daily copper price with the gold price mapped against it. Note that while copper peaked in early 2011, the gold price has kept pushing to new highs. This perhaps reflects the disconnect between the primal movers for these assets. While copper is expected to preserve it’s value in real terms (the destruction of money meme) – there’s no getting away from the fact that it is an industrial commodity. Gold on the other hand is almost purely a speculative asset – meaning that it is only worth what the marginal buyer is convinced its worth – it has little utility value.

So with the tailwinds from global stimulus nothing but a sweet memory, and the threat to the world order alternating between debt concerns in Europe and the US, and with China pursuing its very own debt funded growth model, maybe it’s not so surprising that copper has been weak.  The question is really whether this weakness is a precursor to a deeper correction.

Notably this weakness is broadly matched by declines in the oil price and industrial commodities more generally.

Turning back to gold, it makes you wonder as to whether it can sustain its price strength if the rest of the market is crumpling around it. Certainly, should copper track lower the copper to gold ratio would be plumbing new depths in the absence of a similar move by gold.

The logic goes that while China accounts for just over 20% of non-oil imports into the US, it is the marginal price setter in key sectors that determine prices for commodities as well as consumer goods.  The import prices of goods from China since 1997 is illustrated in the following chart:

It’s notable that import prices trended down across the period – until the RMB was allowed to start appreciating against the USD (that’s the light blue line in the chart). From 2005, the prices of industrial supplies have taken off as these are more sensitive to movements in underlying commodity prices. Note too, that while the RMB has been permitted to appreciate by 20% from 2005 to 2009, consumer prices were only up 7%.

But from mid-2009 onwards, consumer prices have kept pace with the exchange rate:

And perhaps the most obvious catalyst are the rising labor costs in China:

This of course must happen if the root cause of the trade imbalance between China and the US is to be addressed – that is Chinese living standards have to rise relative to the West. Rising wages are also necessary if Chinese consumption is going to rise as a percentage of GDP.

It’s just that the risk is that with all this loose money floating around, the compounding effects of rapidly rising Chinese unit labor costs could get out of hand pretty quickly. It mightn’t be a problem for today, be it is a reasonably likely scenario for tomorrow.

So Chinese equities were first to accelerate out of the GFC lows fired up as they were by the sizeable fiscal stimulus that was directed particularly at infrastructure expenditure. Equities ran hard and fast peaking in early August 2009.

Meanwhile commodity prices themselves didn’t bottom until March 2009. And while they responded to the Chinese stockpiling that was conspicuous through to late 2009, prices themselves were relatively restrained in their appreciation. Until expectations of QE2 began to surface that is. From the correction lows in mid-2010, commodities prices have been on a tear.

For mine, this latter leg in commodity prices has been a investor driven phenomenon – whether it’s a response to the supercycle story or the fear of the failure of paper money. I’ve slotted the Baltic Dry Index into the background – as an admittedly flawed indicator of Chinese demand for bulk commodities – as it seems to make the same point.

Putting aside the issue of what factors have driven commodity prices higher, the fact remains that Chinese equities have been in a relative downtrend ever since the middle of 2009. The obvious conclusion is that higher commodity prices are bad for a infrastructure-build driven GDP. Is this exposing a key flaw in the Chinese growth model – that the more (debt-funded) investment is plowed into infrastructure, the higher commodities prices are driven and the larger the problem when this model is brought to its inevitable end?

It’s a valid question – as when we look inside the relative sector performance of Chinese equities since the beginning of 2009 we see that it is the energy and materials sectors that have been ‘holding up’ the composite index – or put another way, it is the financials in particular that have been hanging heavy around the neck of the Chinese equities markets. Are the financials hinting at what is to come?

The key insight of Didier and his comrades is that financial market prices tend to follow a power law as they accelerate into bubbles. Specifically, they fit a log periodic function to observed price movements to forecast the evolution of prices to a ‘singularity’ whereupon prices collapse.

I’ve been reading the pieces coming out of the observatory for a while. They appeal to my fatalistic nature, in addition to mirroring the trader’s wisdom that parabolic price rises tend to end in tears. (Note, I’d caution that forecasts can be subject to revision based on ‘new information’.)

One of the latest papers, “The Second Wave of the Global Crisis” (published 3rd July), has a satisfyingly specific target for the end of the ‘gold price bubble’ – 27 July 2011 (here for the full piece). Following is a chart from the paper. The thick black line that sits over the gold price illustrates this price acceleration and the forecast terminal point:

…the thin line indicates daily gold price between November 3, 2003 and May 26, 2011, whereas the smooth thick black line has been generated by the following version of equation (1) with parameters chosen by the least squares:

p(t) = 1978.2 – 734.8 (2011.573 – t)0.36 {1 + 0.024 cos[16.5 ln(2011.573 – t) – 36.3]}, (1b)

where p(t) is gold price at the moment t. Note that the quasisingularity moment (tC) here equals 2011,573, which corresponds to July 27 and suggests that the gold bubble should start collapsing before this date anyway.

Where once China exported deflation to the globe as its workforce migrated to the cities and competed with the developed world in manufacturing, now this burgeoning urbanised population requires accommodation, roads and railways. China is competing with Australians for their own natural resources – and so prices must climb higher. This is the logic that underpins the huge investments currently being made to extract yet more resources out of the earth at an even faster pace. (Whether this logic has been perverted by capital markets is an argument for another time.)

One of the prices that has climbed higher has been the Australian dollar relative to just about everything. We’ve argued for a couple of months now that this year’s spike has taken the currency beyond the realms of reasonable – that the extrapolation of China’s implied thirst for resources was excessive given the risks to it’s growth model. So to the latest “Cost of Living” survey by Mercer (here) that identifies the world’s most expensive cities – Australia gets a special mention:

And the primary reason (it wasn’t because house prices went up or the cost of consumables climbed faster than our international peers):

All six cities jumped at least 10 places between their 2010 ranking and their 2011 ranking – and two, Canberra and Adelaide, jumped 40 or more positions. This movement is due primarily to the recent strength of the Australian dollar, which appreciated by almost 14% against the US dollar over the 12 months considered. Consequently, a New York City assignee would need more US dollars to purchase a similar basket of goods and services in Australia, and the Australian cities’ rankings all went up.

We may yet see a thrust of Chinese national hubris that will take commodity linked prices to as yet unseen peaks, but I’m confident that history will view the current period as an aberration rather than the status quo.

You’d think that weakness in the China growth engine would be reflected in commodities prices – but the charts would suggest otherwise.  Consider that bellweather of commodity demand – copper:

Apologies for the somewhat crowded chart, but it’s interesting from a few perspectives – starting from the top:

1) The copper price has rolled off its highs but has materially lagged the selloff in Chinese equities. As we have discussed previously (most recently here and background here), the Shanghai Composite has been led down by the resources and financials sectors. Eyeballing the relative price movements suggests that equities tend to lead the copper price – particularly at turning points.

2) The copper price has been diverging from equities since the start of March. With domestic tightening leading to unwinding of copper inventories in China and difficulties in its property development sector, it’d be reasonable to expect copper to follow the equities markets lead rather than the reverse.

3) I’ve included the RSI for copper to illustrate that the price could fall someways before becoming oversold by this measure. Notably, the MACD looks to be crossing over again – suggesting that momentum is turning against coppers price.

Finally, and in some ways following on from yesterday’s post about the impact of the investor class on commodities prices, consider the following chart that maps US equities against the copper price.  For mine, the correlation says a lot about US monetary policy, its impact on investors, and the resultant movement in the copper price.

Commodity prices are currently both high and volatile relative to the past few decades, consistent with the physical supply and demand fundamentals that underpin these markets. However, the increase in prices and volatility is not unprecedented, having occurred during other large global supply and demand shocks throughout the past century. There is a lack of convincing evidence (at least to date) that financial markets have had a materially adverse effect on commodity markets over time periods of relevance to the economy. It is possible that speculators have had some effect on commodity price volatility, but their contribution would appear to be relatively small – particularly when compared with the contribution from fundamental factors – and short term in nature.

If we line up the central banks with the papers they have published, we get some interesting correlations (apologies for the simplistic paraphrasing):

Federal Reserve – commodity prices are driven by physical demand from emerging economies; not our monetary policy

Bank of Japan – commodity prices are higher than physical demand alone implies; we should know, we are a commodity importer

Australia – commodity prices are driven by ever increasing demand from emerging economies; we should know, they are our best customers

Hmm.

Speaking of correlations in the commodities markets, RBC published an interesting chart recently (via FT) that compares real copper prices to inventories:

All those grey circles in the upper left quadrant are telling us that the last decade has been very different to previous ones – prices have remained stubbornly high against relatively stable supply. The big question is why?

Clearly, demand from China for industrial resources has grown very strongly, just as it has risen for agricultural products and energy across the developing economies. This supports the argument that the growing demand in absolute volume terms requires a higher level of inventories on a weeks-of-consumption basis. There is no doubt then that higher demand from China et al has pushed up prices relative to the experience of the prior two decades.

But to downplay the impact of investors that have plowed relentlessly into the supercycle commodity story, as the RBA has done, is plain irresponsible. It is self-evident, to me at least, that the weight of investor money in the sector means that this capital flow is capable of being the marginal price setter. With commodity investors making up some 40% to 50% of futures markets turnover, can they really be anything else?

We’ve discussed this before (in May last year here and with some charts from James Montier here). The evidence is plentiful – from the volumes being traded in futures markets to the distortions being created in the forward curves.

If nothing else, the growing presence of investors increases the potential for extreme movements in commodities prices. It is well to remember in this context that commodities as an investment in their own right do not pay a dividend. Investors rely solely on higher prices to generate returns – or at the very least, stable prices to get their money back.

Still when you look at this chart from the RBA’s analysis, one gets the sense that the supercycle proponents are comfortable with the risks for some time yet. To be fair, it’s a pretty compelling picture…

From the centennial issue of The Sydney Mail (21Jan1888), we have these front page reflections on the allure of investing in mining…

The last week has been remarkable for one of those sudden and spasmodic developments of speculation in mining shares, of which we have had several specimens in the past, and seem likely to have several more in the future. Mining in the colonies has been marked by sudden gains and wearing losses. If all the losses were put in one scale, and all the gains in another, the latter would not preponderate very largely; but the few great and rapid fortunes hat have been made constitute an irresistible temptation to the adventurous….

As to what the ‘speculation’ was – from the Sydney Morning Herald on Thursday 19 January:

The main and all-pervading topic in mining circles during the part fortnight has been an extraordinary, and almost phenomenal, “boom” in connection with the values of silver stock. The actual cause of the sudden runup of prices was the establishment of the fact that the Central Broken Hill Company had met with…a looked-for and well-defined silver lode.

Now clearly the Broken Hill region was destined for greatness - The Broken Hill Proprietary Company (now the world’s largest miner) was formed in 1885 after a boundary rider dusted off a silver deposit in the region. As Leonard Dodds, a mining agent said at the time, after his ‘thorough, and official, investigation’ of the Broken Hill silver mines, “the Broken Hill mine itself is undoubtedly one of the marvels of the age”.

It’s that greed is so infectious that is interesting. All silver stocks rise on the back of the one great lode. The mal-investment that results is equally contagious and contaminates all resource sectors. It is notable that the late 1880′s were the tailend of a mining boom that began some twenty years before – the depression of the 1890′s was beckoning.

There is little doubt that hidden amongst the current capital spending boom, that is slated to continue for the next 2 to 3 years, there are likely to be the next investment disasters. Mines that are uneconomic at lower metal prices. Shale gas deposits that have questionable environmental impacts. Still it was The Sydney Mail who coined the phrase, ‘resistance if futile…for the adventurous’.

The question is whether the recent stalling in the copper price is reflective of this same effect:

Seems like a reasonable argument.  Take for example this FT article (here) that Chinese copper imports are being re-exported into LME warehouses as Chinese traders can no longer finance inventories on the mainland. Estimates are that there are over 700,000 tonnes of metal sitting in bonded warehouses in China that would avoid the 17% value-added tax if it were to be re-cycled in this manner. This activity is consistent with a 43% drop in monthly copper imports to 192,161 tonnes in March compared to the same month last year (here).

According to the rules of the Silk Road, we could reasonably expect these flows to feed through to global markets. And looking at the most recent commitments of traders reports, it appears that this is indeed the case. Open interest has dropped since peaking in late January.

Looks like its been hedge funds that have begun to wind down longs – seen in the new format COT reports as money managers:

To place this chart in the longer term context, following is the old format report – copper longs remain elevated:

Whether this is signalling a slowdown in China demand for all things resources remains to be seen. It’s notable that electricity consumption is still growing at a healthy clip (here) – this bears further investigation.