Seeking Balance

The global sell off of the past week was in part simply the profits taking that happens this time of year, and in part a number of our running themes being confirmed during this year’s shortest month. These are the US housing market, concerns about overall US debt levels, and the fact that East Asia will increasingly steer markets. We continue to believe we are moving towards a broader audience for the resource sector.

There could be further pause if the entire equities sector consolidates due to US weakness, but that is in keeping with the start of the second stage of a secular resource bull market. The resource sector took a steep drop because it has had a large upside run. When pressured or scared into selling, traders try to make it painless by harvesting profits first and the resource sector has provided more of those than most. Prices have started to recover. That does not mean there will not be another slide while the adjustment to looking east rather then west for the markets’ psychological underpinning continues. This is especially true given the difficulty in reading some Chinese stats, and the fact that China is after all still very much an emerging market. But, before the slide came firming in the resource sector due to China.

A bottoming for copper came early in February in spite of the weakest US housing numbers in almost a decade. Copper is a leading indicator, and it was last year’s price swoon that foretold housing weakness— demand slackened when builders put the brakes on new projects, because of government induced cooling in China and simple lack of demand in the US. Copper price gains resumed with restocking in China this year. Demand on the Shanghai commodities exchange along with stocking information on the London Metals exchange now combines to give traders direction for copper and other base metals.

It was also Shanghai, with help from Tokyo, that generated created the tipping point for the market correction. It is important to note that the global impact had a Chinese trigger but little actual impact in China, and that China may have been the flag drop but was not the actual cause of the selling. It’s also worth remembering that China’s stock markets are wild at the best of times. The nine percent swoon that shocked the world took the Shanghai Index back to where it was only two weeks earlier. Nine percent is unusual but daily moves in the 4-6% range are not uncommon on Shanghai.

The lunar New Year correction on the Shanghai Stock Exchange simply signaled profits taking elsewhere. At a basic level it was a normal reaction to a volatile market that gained 130% last year, and did come after China’s New Year break just as selling came to resources in January after the western New Year break. Beijing started this year of the Pig with further tightening of loan provisions and an increase in reserve ratios for the banking system. Then a rumor got started that a capital gains tax on stock market gains was coming. After the government stated the next day that no capital gains tax was planned, Shanghai started a recovery. In brief, a normal correction to a hot market.

That scare generated correction however extended into a second significant movement already underway, and one we have said in the past would mark a shift in sentiment. That move was to the Yen after the Bank of Japan raised its lending rate from 0.25% to 0.5%. Though hardly a burden per se, that interest rate gain was enough to begin the unwinding of Yen-carry trades.

Carry trades involve borrowing in low interest rate environments and using the funds to invest in higher rate environments. The trader executes these linked sets of trades in order to capture the interest rate spread, or “carry” between the two regions. In theory, the trader is trying to create an “arbitrage” transaction, defined as a set of trades that cancel each other out and (hopefully) leave the trader with a small profit based on price differences between items simultaneously bought and sold.

The clearest example of this is traders buying and selling shares in companies that have agreed to merge until the prices of the companies shares are in line with the merge ratio. In practice, carry trades are not really arbitrage trades at all. Carry traders are exposed to currency risks. Yen carry traders are selling (shorting) the Yen as part of the trade. This worked well while the Yen has been weakening and it’s safe to say that the Japanese were fine with the idea. They had a weak Yen policy anyway and the carry traders were just helping the cause. That has reversed, and that was the past week’s real issue. It’s widely believed that the Bank of Japan came under enormous pressure at last month’s G7 meetings over the issue of the carry trade. Central bankers were concerned about the distortions it was creating in the markets. The fact no one even knows the extent of these trades, other than that the lowest guess exceeds $100 billion didn’t help either.

The BoJ move came on February 21 and though it strengthened the Yen, the move was not large. Carry traders probably felt safe in the knowledge that Japan would continue the weak Yen policy it has followed for years. Perhaps, but when Shanghai dropped 9% on the same day that continued weakness in US mortgage lending, housing and dismal US factory orders were exposed, fear began to replace greed. This was aided and abetted by a number of central bank chiefs. There was plenty of commentary pointing out the risks of the carry trades and dangers in highly leveraged currency bets.

Fear that US interest rates might drop after the weak economic stats merely accelerated unwinding of yen carry. This meant selling whatever had been purchased with this borrowed yen to create the cash needed to close the yen loan. Over the past week as Yen was bought and greenbacks sold to close positions the ¥/$ rate dropped 4% to below 116 before stabilizing, enough to wipe out the interest rate differential between Japan and other hard currencies.

Although a lot of carry trade money finds its way into US Treasuries, funds from yen carry had also been put into to higher risk areas like equities and metals contracts, especially gold that in normal weeks would act to hedge against a US$ bond purchase. So unwinding the yen-carry included selling shares and gold in order buy Yen. That created a spiral of red, and a much greater risk aversion.

On a side note, we were surprised by the reaction of many analysts and talking heads to the downdraft in the gold price during this period. We were watching screens when the two main episodes occurred and it seemed obvious to us that gold was being sold in bulk by someone unwinding larger trades. Many commentators read all sorts of dire things into the fact gold didn’t behave the way it was “supposed to”. Many gold bugs have spent the last few years struggling to achieve respect for the yellow metal as an asset class and a part of everyone’s portfolio. Based on the price action during the correction it looks like they succeeded. Gold was, in fact, behaving just the way you would expect an asset class to. It was being traded along with everything else. Traders that wanted or needed to zero out their portfolios were selling gold along with everything else. Because they could.

Is it over? That depends on the “it”. The immediate impact is behind us given the stabilizing of currency markets today, but it really comes down what those off side may have to deal with. If there is a group still seriously off side that could create more selling, but we don’t expect that to be lasting. As likely will be attempts to further reduce the yen-carry at official levels. In theory the yen-carry should help strengthen Japan’s recovery since it keeps the yen low and helps Japanese exporters to compete. This has happened and even though the Japanese domestic economy has continued to be weakened by deflation, it is past due to see interest rates move to more realistic levels.

The best medicine for the weak consumer spending in Japan is probably the psychological boost of a strengthening yen bringing down the cost of imported niceties. And there needs to be a balance in exchange rates for a US$ that is too strong for the US to retain high cost sectors like manufacturing. US administrations have long been supporters of the weak Yen policy. While this might be mainly due to camaraderie and the desire to see the Japanese economy back on its feet it’s definitely not lost on US officials that a lot of carry trade money finds its way into and supports the US treasuries market.

The US debt burden is the biggest issue hanging over this market. That was the real reason for the unwinding of high risk trades we have just seen. A scare out of China simply reminded traders that markets do carry risk even when low interest rates are indicating otherwise.

Although the equity markets have quieted down expect more problems from the sub prime mortgage arena. We won’t go into that at too much length right now, but it’s a sector that is likely to create headaches for many. Though some sub prime lenders are owned by larger institutions few of the heavyweights in the sub prime markets are deposit takers. They originate mortgages but are dependent on the kindness of strangers to fund them. That’s actually the good news. There won’t be huge losses of depositors’ money like the S&L debacle.

Because mortgages get bundled, securitized and resold the credit risks are spread out. Again, good news—to a point. The bad news is that as mortgage defaults soar the sub prime lenders costs of capital are soaring with it as their lenders demand higher risk premiums. In fact, many lenders, including Freddie Mac are now refusing to keep lending for these exotic loan types. The first casualty is the sub prime lenders themselves. We expect this industry to virtually disappear by the time the leaves turn this fall.

The bigger problem is what to do about the 10-20% of borrowers who won’t meet new stringent lending standards. Banks don’t want to be in the real estate business. They will work with borrowers but many loans will be unsalvageable and foreclosed. A growing number of borrowers who have no or negative equity will simply walk away from their homes. In short, there is a lot more distressed real estate headed to market in coming months. That will weigh heavily on the US economy until the excesses are worked through and risk premiums and lending standards are back to something approaching normality.

There is no simple balance between the need for higher risk premiums in US debt and the need to see a lower US$ to aid US exports. It will require time, and a decline of US economic power, to fix. Just as it has for previous economic powers. This is and will continue to create turbulence, until a balance is found in the continuing move towards the new economic centre in east Asia for leadership. A weakening US$ will for the time being help underpin gains for commodities that use it for pricing. Our expectation is that a, generally, slow decline of the $ against the yen in particular has now finally started. However, in the final analysis what we will see going forward is moves in metal prices based on fundamental supply-demand pictures. Right now that means, so long as there is no major change in China’s forward movement, that most will have fairly steady markets as weakening demand in US is replaced by demand gains elsewhere.

We do have to look in the mirror occasionally and wonder if we are not simply drinking our own bathwater. Several days into this year’s Prospectors and Developers Conference in Toronto, the largest annual gathering of mine explorationists (yes, that term is in use by the sector’s technicians) the same might be said for the sector as a whole. Underlying certain buoyancy among PDAC participants due to high metal pricing is a seriousness of intent. The nature of mine finding and development is also under change, and how best to accommodate that in a reasonable fashion is an unspoken theme. So long as that persists, the underpinnings of wealth creation by the sector are in place. More on that in upcoming issues. Ω

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information.

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