Shipping has been reconsidered

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Good morning. What looked like a rally in US stock markets yesterday turned into a decline by the end of the day. Whatever problem we had, we still have. Send us your diagnosis: [email protected] and [email protected].

Shipping has been reconsidered

Everyone loves a simple phrase that covers a complex phenomenon – even more so if it sounds a little sophisticated. Enter the “carry trade,” or even better, the “carry trade expansion,” which have been floated as an explanation for all kinds of market chaos over the past week or so.

We wrote that we see no evidence that the volatility in US stocks in particular is stemming from the carry trade. It seems more likely that the causality is the other way around. After talking to people who understand Japanese forex markets and finance better than we do, we’re still thinking about it.

Most loosely defined, a carry trade is just using capital from low-interest countries to buy high-yielding assets elsewhere. This covers all Japanese institutions and households that have used a cheap yen to invest abroad. Some of this flow may reverse if the rate differential between Japan and the rest of the world continues to close. But that’s not what’s happening now. Here’s James Malcolm from UBS:

Japanese outflows were largely in the form of foreign direct investment. . . (after the Bank of Japan raised rates) haven’t fundamentally changed their appetite for risk – Toyota isn’t closing factories. They invest abroad for growth and access to labor. And Japanese (institutional) investors are similar. When buying foreign stocks, it is for growth and diversification of earnings. It may have sold some foreign AI holdings, but it is unlikely to start repatriating in a big way. And Japanese retail investors in particular have few offshore assets.

More narrowly defined, yen carry trades represent foreign exchange bureaus and hedge funds borrowing yen to invest in other higher-yielding currencies or fixed income products. UBS’s Malcolm estimates that since 2011, there has been a cumulative $500 billion in yen trades. And the yen’s jump and the decline in higher-yielding currencies suggests that the dollar-yen trade and some of these other yen trades have indeed eased:

These deals tend to explode for two reasons. First, when there is a change in interest rate differentials that make the trade unprofitable. There has been a slow move away from yen trading since March when the BoJ lifted rates out of negative territory. A rush for the exits based solely on the BoJ’s 15 basis point hike last Wednesday seems rather odd.

The second type of trigger is a volatility shock. From Mark Farrington, Global Macro Advisor at Farrington Consulting:

(A volatility event) pushes (traders) to reduce their forex carry positions. . . the inputs to the risk management model will be generalized indicators of volatility, not necessarily just currency volatility. Large losses in US equity trades that are funded in dollars may further force risk adjustment in trades funded in yen and vice versa.

So the stock sale could have triggered the carry trade, not the other way around. And the timing suggests that this has happened. The sell-off in stocks did not begin in earnest until Friday last week – two days after the BoJ raised rates or after currency traders had time to digest the news.

Markets being markets, after the sell-off in stocks triggered the yen carry trade, the carry trade could then have exacerbated the sell-off in stocks – especially since everyone shouted “carry trade!”. But they are separate phenomena, and while the yen trades bearish (narrowly defined) it looks likely to continue to ease, that alone does not necessarily mean global equities must remain under pressure.

(Reiter)

Can copper be a long-term investment?

In mid-September last year, Unhedged wrote about copper. The argument was that the green transition – if it actually happens – will require a lot of copper for electric vehicles and new power grids, and the prospect for a new copper supply does not seem deep enough to meet what is needed. Therefore, those who believe in the transition should be exposed to rising copper prices.

Our column made us feel smart. The price of copper rose more than 25% between September and May, and the share price of Freeport-McMoRan, the main copper miner, rose 40%. But like so many things that make journalists feel smart, the trend didn’t last. Since the peak in May, the price of copper has retraced almost all of its gains.

As colleagues at the FT wrote last week:

Declining Chinese demand (caused) fund managers to shed around $41 billion of bullish bets on natural resources.

Sale in copper. . . has been particularly bad – it’s down almost 20% from May’s record high of more than $11,000 a tonne. . . Traders’ bullish positions — excluding bear bets — on commodities fell 31 percent, or $41 billion, from a late May peak of $132 billion through July 30, according to data from JPMorgan . . .

Much of the copper China bought in the first half of this year ended up being stored rather than used.

Manufacturing industries are in contraction worldwide. China’s real estate market has not recovered as hoped. And Copper’s AI narrative — the idea that data centers will need a lot of it — may have been overblown.

Meanwhile, the long-term case for copper is unchanged. All I’ve learned is that price volatility and shipping costs make this case very hard to invest. Jeff Currie, a commodities strategist at Carlyle and former Goldman Sachs head of commodities, believes another copper supercycle is ahead. But as he argued in a recent note, a change in market structure has made it harder than ever to bet on:

What makes this period different from the previous cycle in the 2000s is the market’s reduced ability to sustain long-term risk on behalf of these industries, meaning that commodity investment to meet this increase in investment demand will have to wait more until the environment is much safer.

Capital rules after the financial crisis radically reduced the amount of capital banks would risk in commodity futures markets, making those markets thinner and less reflective of fundamentals. Moreover, the macro hedge funds that played an important role in commodity markets 10 or 20 years ago have been replaced by algorithmic traders, momentum hunters and “bridge” funds with low risk limits. Therefore, the price impact of imbalances between supply and demand is not felt until the imbalances have actually arrived. As Marcus Garvey, Macquarie’s head of commodity strategy, told Unhedged: “We have to accept that commodity markets are, in a way, still spot markets. They don’t really ignore the future.”

For copper investors who are willing to endure the volatility of a myopic market while waiting for the green transition trade to pay off, owning mining stocks is the only viable trade. It is the only one with a positive carry. But one wishes the transfer was higher: Freeport’s dividend yield is under 2% and its free cash flow yield is less than 3%. Other miners offer better returns but are higher cost copper producers or have more exposure to other metals. One comforting thought: The market may offer more attractive entry points for copper trades if the economic slowdown worsens.

A good read

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