Wednesday, September 28, 2011

Trade Idea: Treasuries vs Copper ($TLT $JJC $DBB)

Noted deflationist Gary Schilling via Zero Hedge:

"I'm agnostic on the precious metals. We have in our portfolios been short copper. Copper peaked out in February and it's down about 25% from its peak. I think it will go a lot lower. As you pointed out, copper goes into almost anything manufactured. It's a great indicator of global industrial production. What I think will really knock the pinnings out from under all commodities is a hard landing in China, which is what we're forecasting."
Copper is the best deflationary bet. In fact, you could short the 30 year Treasury and short copper and probably do well either way. To put it another way, last time long-term interest rates were this low, the price of copper was closer to $1/lb instead of the current $3.20/lb.

One of my favorite types of trade is to look at two different markets that should be keying off of the same fundamental variable, but aren't, implying an inconsistency. [That way, you are agnostic about what exactly the future will look like, just betting that an empirically and logically justifiable relationship should continue to hold.] So the long-term U.S. interest rates are screaming deflationary depression but copper prices aren't.

Why might this be? A regulatory arbitrage scheme in China seems to have artificially boosted the demand for copper over the past several years. Apparently, importing copper is or was a way for Chinese businesses to circumvent their government’s restrictions on lending.

My understanding is that the long-run marginal cost of copper is in the mid $2s/lb, i.e. 25% lower than the current spot price. However, if there was going to be a depression of the type that the Treasury market is implying, the price of copper should be closer to the 2008 low. That would happen instantly if the Chinese copper stockpiles were put on the market, perhaps due to forced liquidations.


CP said...

P.S. Obviously you need to be bearish on the U.S. nickel coin if you are bearish on copper/base metals.

CP said...

Further to the suspicion that much in the way of Chinese metals imports are related to schemes to game the cheap money there by circumventing capital controls – -whether in order to bet on Yuan appreciation or commodity price rises, or both – note that the relative prices of copper, aluminium, and zinc in Shanghai vis-à-vis that on the LME bear more than a passing resemblance to the volume of new loans concurrently granted by Chinese banks (including a rough estimate of ~CNY1 bln for January, as widely bruited on the newswires).

CP said...

Would anyone take the other side of this trade? Long treasuries and long copper? What would you have to believe in order to hold that position?