Metals Market Equations Are No Longer Simple

By: HRA_Advisory

World events continue to signal support for hard assets, but caution is still advised. News in the copper space is as much about consolidation of the players as the metal itself right now. The $7 bid by China Minmetals for Equinox Minerals (EQN-T, ASX) has offered some support for other mid tier copper assets. The Minmetals bid requires EQN to drop its own bid for Lundin Mining (LUN-T, LUNMF-Q) that had already squelched the planned merger of LUN with Inmet Mining (INM-T, IEMMF-Q). EQN had already merged with an Australian junior to acquire its Saudi copper mine development that is to begin out put late this year. To this has just been added a take-over bid by Capstone Mining (CS-T, CSFFF-Q) for Far West (FWM-T, FWMLF-Q) and its copper-iron project in Chile, with an assist from state owned Korea Resources Corp. Small and mid tier copper producers are focused on securing growth assets of the right scale as Asia gets more aggressive in ensuring supplies for its markets.

That's enough to and fro for even the most ardent resource sector bears to give the sector another look. The interest in copper equities has contrasted with weakness for the metal's fundamentals. The three-market (LME, SHFE, COMEX) inventory levels for the red metal are back up to levels similar to those at the copper price low in March '09. The biggest build up through that period has been in Shanghai where stocks actually went negative in early '09. (Of note is that the SHFE now breaks out "bonded" metal which has been delivered to a Chinese port but hasn't had duties paid for entry.) This extra stockpile will work through the system in time, but it is large enough to have broadened the call for near term weakness in copper's price. The looming structural deficient in copper supply still has producers looking for near term additions to their output. That should continue to support copper assets with well defined cash flow potential. Near term weakness for the red metal can still be viewed as an aid to picking up asset rich deals.

Base metals and globally priced commodities more generally also continue to see support from US dollar weakness. Dollar weakness and inflation are somewhat perversely linked. At the start of the year many expected strength in the Dollar based on higher growth forecasts for the US. The rise of the Arab Street and $110+ oil prices changed the picture. If a ceasefire in Libya calmed that region the oil price at least may be less of an issue. That's still a big if. High oil prices definitely hurt in 2008 but much of the following recession was baked in the cake by the real estate bubble. Mayhem in the Arabic could generate a real time experiment on the breaking point from rising oil prices this go around.

News that tightening moves in China don't seem to be biting yet has added to concern on the oil, but in balance we think China will continue this tightening until they do. However, near term Euro strength may ironically have the most influence Dollar pricing.

The ongoing debt crisis in Euroland is one reason many expected the Greenback to keep strengthening, but Portugal finally succumbing to its debt reality caused barely a ripple in the markets. The amounts involved are small enough that the larger Euro economies should not have much trouble absorbing those costs. That is not yet the end of the story. It's widely assumed the next domino to fall could be Spain. The cost of a Spanish bailout would be an order of magnitude higher than Portugal, and the market would be much less sanguine about it. Spain continues to insist a bailout is unnecessary, as did Greece, Ireland and Portugal until right before they threw in the towel. Given this backdrop the strength in the Euro would be surprising except for one thing -- the European Central Bank.

The ECB has credibility as an inflation fighter. It raised interest rates again this month by 25 basis points and made it clear it would continue to if it sees evidence inflation continues to accelerate. This sort of credibility is the reason the Euro has been strengthening. The US Dollar Index has now reached new 52 week lows, largely due to Euro strength.

Inflation is also rising in the US, but messages out of the Fed and Washington politicos are as mixed and contradictory as ever. While it seems unlikely there is the political will or necessity to institute "QE3", it's equally unlikely the US will follow Europe's lead with interest rate increases anytime soon. The US Fed tracks GDP price deflators and core inflation numbers that are still steady since they exclude food and energy. The "QE3" issue revolves around the lack of demand for US Treasuries. The Fed has been the buyer of last resort in the treasury market for some time now. PIMCO, the world's largest bond fund has sold what had been the biggest private holder of US treasury bonds, and gone short Treasuries.

The US Treasury yield did drop in March as the safety trade took hold, but that reversed fairly quickly as the markets started to normalize later in the month. During this period the Dollar itself barely benefited from the safety trade. There was some uptick as rates moved up but this soon dissipated and reversed. Despite worry about bonds selling off, Treasuries are still a parking spot for funds. That might change with another interest rate gain in Europe. If that happens PIMCO would have lots of company on the short side of US Treasuries.

Meanwhile, China still refuses to let its currency appreciate. And, recent economic stats increase the likelihood of more rate increases there. China's Q1 trade statistics were headlined with a trade deficit, the first in years, but the numbers for March indicate strong gains for both imports and exports and a small trade surplus for the month. Numbers like these indicate China is still the world's widget maker.

Like the ECB, Beijing is serious about tackling inflation so more interest and reserve ratio increases seem certain. The Yuan should be gaining while this tightening continues, but Beijing still seems to be more concerned about losing sales than allowing a stronger currency to knock down import costs and help cool inflation. With China trade so important these days, that eats into everyone else's wiggle room.

Assumptions that the US Fed will avoid raising rates to fight inflation are none the less still quite rational. Moderate inflation debases US debt, and it's simply not that easy to argue with the world's biggest debtor. The US will try to maintain a negative real interest rate policy for at least the rest of this year. As long as the market is letting them get away with not spiking Treasury yields it makes no sense for the Fed to change tack -- unless forced to.

More hawkish central banks trying to stay ahead of the inflation curve will continue to attract bond holders. This will maintain a benign environment for metals and other commodities, even if it does not push them to higher prices. However, as rates outside the US move higher it will become more difficult for Washington to roll over its debt without following suite. The S&P downgrade of US debt recognized that simple truth. We aren't yet at that point of concern and may not be soon, but it has potential to be turning point when it takes place.

Gold and silver have continued barreling higher thanks to insurance buying, inflation expectations, and the currency picture. Given the underlying chaos in global affairs there is room for gold and silver to continue their gains, in US Dollar terms at least, as long as negative real rates persist in the US. Around that upward bias will be traders moving in and out of the safety trade and other short term sentiments. Expect volatility.

Gold's advance has been fairly measured, with plenty of consolidation along the way. Pullbacks have been few lately in the silver market. Silver looks technically stronger, but it will be prone to sharp pull backs given the large one way move it has already had. Silver's strength has shifted a number of companies we follow from being gold dominant to silver dominant just as they are reaching cash-flow waypoints. These are safer ways to play silver after its strong gain, so they have been getting some emphasis in our updates to subscribers. We are looking at a few exploration stories that may offer better silver leverage, but we do so cautiously. Market shifts can impact smaller metal markets swiftly, and unpredictably.

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By David Coffin and Eric Coffin
http://www.hraadvisory.com

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery; a family of publications that are focused on metals exploration, development and production companies. Combined mining industry and market experience of over 50 years has made them among the most trusted independent analysts in the sector since they began publication of The Hard Rock Analyst in 1995. They were among the first to draw attention to the current commodities super cycle and the disastrous effects of massive forward gold hedging backed up by low grade mining in the 1990's. They 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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Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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