June 2013 - Richard 'Jerry' Haworth: Copper parity party

Two new grey swans roosted on the risk roof this month that probably deserve a passing glance.


The first is copper and other precious metals and their unusual growth in bonded warehouse stocks in China. There seems to be an interest rate arbitrage between the Chinese currency traded offshore versus onshore as well as a healthy dollop of credit creation thrown into the mix. Central to the “round-tripping” was the use of Letters of Credit which in turn needed a reason to trade, namely physical metal stocks held in warehouses. Chinese authorities have moved to stop the practise in early June which seems to lead to a precipitous increase in inter-bank lending rates in China and corresponding drops in metal prices as their collateral qualities were no longer required.


The names change but the game stays the same and the end result is always the same. Nature will always side with the hidden flaw until that flaw is removed.


China is 15-20% of world GDP and a driver of world growth. Data on the reality in China is sparse, information even sparser and intel ever sparser still. Be that as it may, a liquidity turned solvency crunch in China, initiated by the unwinding of the copper financing schemes, could be the “butterfly’s wing” of the next major downturn. Emerging market asset prices in the last month support a view that something more serious is afoot than a common garden variety risk reversion.


The second elephant in the room is risk parity, an investment methodology which has attracted widespread implementation in institutional investment management circles. Bottom line is that this methodology encouraged leverage to further accumulate bonds at all time high prices. One hint by Bernanke that they might end quantitative easing has thrown the bond market into an unnaturally big tailspin - our take, risk parity investing. Just as portfolio insurance made the 1987 crash that much more severe, we think that risk parity could be the poster child for a great bond unwind. Add to this mix that portfolio managers now have the ignominy of watching BOTH bond and equity prices decline together,  something that is technically “off-script” and adding to the confusion and uncertainty they must feel right now.


Grey swans are interesting. They are predictable unlike black swans but just as severe in the consequences they unleash.  Maybe the fact that we can see them leads us to an unnatural complacency? Or maybe a risk known is a risk halved?


Volatility seems to be leaving the station. We have felt the first jolt as the engine moves forward and “connects” the carriages.  What remains to be seen is whether we are just being shunted around the yards again or are embarking on a journey to a new destination.