Having abandoned its equity and credit bubbles, China recently opened the spigots on an unprecedented commodity bubble, as we explained in “Beware The Bubble In China’s Domestic Commodity Market” and “The Stunning Chart Showing Where All The Commodity Gains Have Come From.”
None of that however does justice to what is really taking place. So for an extended view we skimmed a piece by Citi released overnight, titled “Hold onto Your Hats – Explosion in Chinese Commodities Futures Brings Unprecedented Liquidity, Untested Volatility” in which we read the following stunning finding: “trading volumes in Chinese exchanges further spiked, with SHFE rebar and DCE iron ore futures becoming the No.1 and No.3 most-traded contracts around the world, and 11 of the top 20 traded futures contracts are on Chinese exchanges. On 21 April, a major contract of SHFE rebar “RB1610″ reached daily trading volume of US$93 billion, exceeding the total volumes of the Shanghai and Shenzhen stock exchanges combined.”
Putting this in context:
The fact that iron ore, responsible for a small fraction of daily trade in oil and far less important for the global economy than oil, has attracted massive fund inflows in China is an indication of the excesses of Chinese futures exchanges and the dangers that wanton trading on Chinese exchanges may destabilize global markets. Trading in Chinese futures on some irrelevant commodities including bitumen, polypropylene, and PVC have also soared during the past weeks.
The chart below shows this unprecedented explosion in volume in context:
Citi adds that “exploding trading volumes have created large price volatility on Chinese commodity exchanges, a sign of market overheating as perceived by regulators. All three exchanges have therefore attempted to cool down the market by shifting up daily upper and lower limits, raising margins and transaction fees, sending out risk alerts, and banning activities by high-frequency trading accounts.”
So aside from the generic explanation that this is merely the latest Chinese bubble, what has prompted this epic inflow in commodity trading. According to Citi, Chinese commodity futures volumes spiked since 2015 thanks to three factors: 1) domestic liquidity easing; 2) fund inflow from other asset classes, in particular from trading activities in stock index futures; 3) rise of producer hedging in the face of falling commodity prices and volatile RMB.
In other words all the things that prompted the credit bubble in late 2015 and the equity bubble last summer.
One other key factor was a massive short squeeze. “Short positions on iron ore, steel and base metals began to accumulate at the end of last year, accelerating in January as equity investors were prevented from shorting equities during the big China sell-off, partly due to a government crackdown on short-selling equities, and moved to short commodities as a way to profit from a slowing Chinese economy. Roughly after Chinese New Year, they went suddenly long, apparently showing more confidence in the Chinese economy but it was designed as well to lock in lower prices under the assumption that the RMB was weakening over the course of 2016, with higher-priced dollars implying significantly higher RMB prices for commodities in China.”
Citi adds that while the big picture of financialization in Chinese futures market still holds, the most recent rapid movements in Chinese futures market have been triggered by a few more specific factors. For industrial commodities, particularly steel, iron ore, coke and coking coal, an improvement of sentiments on real estate and infrastructure activities since early 2016 has boosted physical purchases of these commodities, leading to a tight physical market with low inventories and rapid surge of prices. More recently, positive sentiment was proved by better-than-expected real estate starts in March, prompting further speculative long positions, a decent proportion of which likely to be short-covering.
The euphoria has been broad based but mostly driven by institutions this time, not retail:
Agricultural products, most notably corn and cotton, also saw a surge of prices thanks primarily to higher-than-expected corn reserve purchase and a delayed schedule of cotton reserve sales.
A simultaneous surge of industrial and agricultural product prices has encouraged massive speculative longs in the futures market. Retail investors have also reported increased participation in futures markets, although we believe institutions are the major driver of the recent rally. However, it is worth noting that open interests in domestic futures market have surged to a much lesser extent than trading volumes for the past few months, indicating that most speculative trades have been conducted through high-frequency transactions, with average tenure of each contract reportedly lower than four hours.
However, while everyone enjoys the leg higher, the question is what happens when the inevitable rush for the exits begins: “When prices start to fall, investors may find it hard to speculate on the futures market by taking short positions, partly as Chinese exchanges require physical settlement for all commodity contracts.“
Others are already looking forward to the inevitable leg lower: quoted by the FT, analysts at London’s Liberium said that “We’ve seen this kind of speculative frenzy before in China in both the real estate and equity markets and the heard mentality has now driven fast money to commodity speculation. Once the upward momentum inevitably runs out, and potentially already has done, the same speculative market forces will drive prices down.” they added. “The situation feels very similar to what played out last year after the Shanghai composite gained 61 per cent in the first half.“
Citi’s conclusion – there are some pros in the recent unprecedented commodity action out of China…
“We believe potential opportunities should rise from the introduction of new contracts, growth of ETFs, and increasing producer hedging activities. We also identified risks to sustainable growth of Chinese futures markets, including physical settlement requirements in domestic futures markets, dangers in an expansion of commodity ETFs, uncertainties in futures market regulations, and limited opportunities for foreign participation.”
But one very large con – once the selling begging, not only are all bets off, but the collapse in commodity prices will reverberate across the entire world:
“all of this growth poses multiple dangers to global commodity pricing stability given how less regulated and therefore less protective the Chinese regimes are for investors, who are perhaps the most speculative in the world.“
Which is why Cit’s warning is simple enough: “hold on to your hats.” In fact hold on tight because now that even Beijing is getting nervous and as reported before, has moved to not only increase trading costs – the Dalian exchange just doubled trading fees and hiked margins – but also reduced night time trading to try and deter some of the more speculative investors, prices have started to tumble.
Then again, a collapse in the commodity complex may be all the excuse that central banks need to try the direct “monetization” of commodities as a last ditch measure before that unleashing the final monetary assault also known as helicopter money.
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