Since May, when the Industrial Metal copper bottomed, the price appreciation has been spectacular, up nearly 15% in almost four months and is up 1.2% today alone. While copper is most often positively correlated with economic activity, a Bank of America Merrill Lynch report notes that other factors might be at play — and it could be time for copper bulls to hedge.
Copper is an industrial metal with high economic activity
Copper is an “economic industrial Metal.” Unlike gold, which is almost entirely an adornment metal, and silver, which is used for both adornment and practical economic purposes, Copper usage is mostly an Industrial Metal . Its primary usage is in construction, followed by electric products, as it is an efficient conductor of electricity.
Because of this use profile, economists consider copper correlated to economic activity. In the middle of its strongest trend move higher towards the end of July, analysts were attributing the move to increased economic activity in China as well as government policy.
“Market participants have gotten excited over an announcement by China’s government to tackle scrap imports, which our strategists believe is supportive of prices near term,” the Bank of America report said.
While there are economic and policy fundamentals supporting the metal, the report titled “Red hot copper at risk of melting on stronger USD” says there are numerous factors at play, not all of them driven by economic fundamentals.
80% of copper's move higher is due to the US dollar, consider hedging with this stock
Driving the copper rally is not just an industrial metal related to economic fundamentals, but also the US dollar.
“With copper being priced in USD like other commodities, the two assets tend to move in tandem whenever the USD stages large moves,” the report said, speculating that nearly 80% of coppers price rise can be attributed to the US dollar rally and not economic factors.
After being range-bound for much of 2017, copper had a “remarkable” rise over the past few months, particularly given “a perception of lackluster fundamentals,” Bank of America observes, pointing to the US dollar as one of the metal's core performance drivers.
The trend in copper could be changing due to several performance drivers shifting course at the same time, some fundamental and others technical.
While economic data has been improving, and copper specific sectors such as construction have seen growth along with demand for the industrial metal, the bank’s strategists “do not expect a sustained improvement in fundamentals, suggesting that the rally may ultimately tail off.”
Driving this analysis are several precepts.
While the economic outlook has been improving, much of this is linked to Chinese fundamentals. But liquidity could start to dry up as China's monetary policy has been “less supportive than a year ago, making a sustained rebound in copper demand growth unlikely.” Further, while China’s recent scrap announcement is a “bullish game changer” in and of itself, it only impacts 10% of scrap imports.
Perhaps most notable, however, is the US dollar. While the dollar could weaken further over the near term, the price trend lower could begin to reverse, particularly against the euro. The dollar has been in a trading range much of 2015 and 2016, but in 2017 went on a significant tear lower and now appears oversold, an analysis that a UBS technical report also concurred with.
What could be interesting is a potential bull short squeeze occurring in copper. With CFTC data showing bullish bets on copper at historic highs, a sharp move lower, particularly one that hits volatility triggers, could see bulls run for cover.
When all the market signals are all added up, one might consider hedging the sharp price increase in the industrial metal – and doing so with a particular stock play.
But doing so with copper futures or options might not be the best bet. Bank of America likes “protection strategies” that use Freeport McMoRan stock as a copper hedge proxy. The world’s largest copper producer is highly correlated to copper prices and, likewise, has enjoyed a strong rally. To gain this exposure, however, Bank of America suggests options put spreads on the stock, with a particular focus on spreads near the 14 to 12 strike price.