China and eurozone remain key factors for metals

After Asian markets were closed, China’s central bank announced that it hikes minimum reserve requirements again by 50bp, the sixth increase this year. The preceding hike was only a few weeks ago and lead to fears in commodity and financial markets that an increase of key interest rates would follow soon. Thus, the speculation on a further tightening of monetary policy by the PBoC could be a negative factor for metals during the final few trading days in 2010.

However, there was also positive news out of China for base metals, in particular for copper, which ended last week at the highest close this year. Last month, China’s customs office reported a decline of copper imports in October. The copper market feared that the Chinese economy would slow down and that copper demand would decline. However, many analysts just overlooked that there was a week of public holidays in October. Thus, the market was again surprised by the rise of Chinese copper imports in November, which jumped unexpectedly by 28.5% on the month. Analysts just watched the arbitrage relationships between the SHFE and the LME, but did neglect the working day effect. We always emphasized that the Chinese economy is likely to expand strongly, which implies that also demand for base metals will be growing.

The euro could not defend the gains made in the week before and pared some of the gains last week. This week, the euro might trade range bound, but the risk appears biased to the downside. The crucial factors will be the bail out of Ireland, where the parliament has to approve the credit package with the EU and the IMF while opposition is mounting, as well as the EU summit at the end of this week. The German chancellor Merkel insists on a solution that includes the participation of private investors (haircut) in the case a eurozone country has to restructure its national debt. She also opposes plans of joint bond issues by the eurozone countries as Luxembourg’s PM Juncker proposed. Given the conflicting views and more and more unfriendly comments from EU political leaders, the risk is quite high that the EU summit is going to disappoint the markets and the euro remains under pressure.

Also the increasing talk that some countries should leave the euro is not helpful to restore confidence among investors. In addition, all those commentators demanding that either Germany or some peripheral eurozone countries should leave the euro play with fire. First, a membership in the euro is compulsory for EU countries, which fulfill the Maastricht criteria, only two countries have a clause that membership would be voluntary. The Mastricht Treaty does not include a clause to leave the euro, thus, many legal experts conclude that leaving the euro would only be possible by also leaving the EU. Second, even if one country would leave the euro, the euro would not cease to exist. In the case that Germany would leave the euro, the banks would face the risk that their assets remain denominated in euros while the liabilities would be converted to the new D-Mark. The banks have made credit agreements in euros and the borrower could insist to redeem the loan in euro. A financial crisis could be the result as banks have to write down some part of their assets. In the case of a weaker country leaving the euro, the banking system of this country is likely to experience a drain of deposits which would lead also to a banking crisis. In any case, leaving the euro appears to be no serious option. However, the ongoing discussion could increase the aversion of investors to hold euro denominated assets.  The dollar would strengthen against the euro despite the possibility of QE3 as Fed chairman Bernanke indicated last weekend in a TV interview.

However, the US dollar could be a headwind for commodities for another reason. We had pointed out earlier, that yields on 10yr US T-Notes at around 2.5% or lower are not attractive for long-term investors given the implicit Fed inflation target for the core PCE at around 2%. The headline inflation might be even slightly above 2%. While monetary policy should be concerned with core inflation, the investor has to focus on headline inflation to maintain his real purchasing power. The extension of the Bush tax cuts, which got more likely after President Obama agreed to extend the tax cuts also for the very rich last week, implies that the budget deficit will be wider than the market expected. As a result, investors sold off US Treasury notes and bonds. The rising yields on 10yr US Treasuries is another factor supporting the US dollar. In addition, it increases the opportunity costs for investors to hold commodities as an investment. Thus, the trend reversal of the US Treasury market could have further negative implications especially for the precious metals. Thus, we still expect that the base metals, in particular copper, to perform better than the precious metals.