MI WEEK IN REVIEW: Credit contagion sends aluminium to 10-month lows

LME aluminium has a well-documented correlation to the S&P 500 so it came as no big surprise that it proved particularly susceptible to the global macro events of last week. The canker in the financial system that is the US sub-prime mortgage sector finally burst last week, spreading its deadly bloom through the global financial system. As the world’s big central banks pumped liquidity into the system to avert a full-scale crisis of banking confidence, LME 3-month aluminium sank to levels last seen in October 2006. Trading in the first part of the week had taken place amid an eerie calm with LME dealers hoping that stabilising stock markets were a signal that the worst of the credit market crunch was over. Bear attempts to follow through from weak closes the previous Friday characterised most of the LME markets and in most cases they proved unsuccessful. For the light metal, well-flagged support at the $2,630/40 per tonne level limited the downside over Monday, Tuesday and Wednesday. Not that there was much evidence of contrarian strength, technical bear funds keeping their fingers on the “sell” button and capping the upside at $2,680. The CTA systematic community moved to net collective short position in May and has increased it ever since, barring the odd roll-back on periods of fleeting price strength. By the close of Wednesday, our fund-watching sources estimated this “black-box” community was short to around 78% of potential capacity, equivalent to a short position totalling around 1,750,000t. Unlike most of its LME stable-mates the light metal has recently received little stimulus either from short-term supply events or from visible stocks movement. LME-registered inventories have been broadly neutral for a couple of months now and last week saw the broad sideways pattern extended. There is a lot of speculation as to whether the Chinese government’s recent moves to close the tax differentials on exports of primary metal and “product” have stemmed the flood of the latter, but last week’s first snapshot of trade in July wasn’t detailed enough for anyone to draw any conclusions. The second snapshot out this week should provide more clues. In the absence of other drivers, short-term price direction has remained a function of that large technical fund short position…and of macro events. The latter burst to the fore last Thursday morning with the announcement by French bank BNP Paribas it was closing three of its funds with exposure to the sub-prime sector to redemptions. The accompanying statement rocked already fragile confidence in the credit markets. "The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," said BNP, raising the spectre of such un-priceable black holes appearing in balance sheets the world over. Cue massive “contagion” with credit spreads soaring and stock markets slumping. The world’s biggest central banks stepped in to pump liquidity into an inter-bank lending system that seemed on the point of freezing. For the LME metals it meant more risk reduction—long liquidation—and more selling by technical funds responding to and abetting in turn deteriorating chart pictures. Aluminium found support at $2,600 on Thursday but more selling from the off on Friday morning sent it down below the $2,580 level before a late, late recovery on the back of a bounce-back in the S&P 500 to $2,590 at the close. It was a week-to-week loss of $55 and the third one in succession, bringing the cumulative decline to $266 over that period. By the end of the week the CTA “black box brethren” had lifted their collective short exposure to an astonishing 96% of historic capacity, our sources estimate. The size of that short has created a massive tension in the front end of the curve. The tension is masked while prices are falling but London locals noted some predatory borrowing within the cash-to-3-months period by those placing bets on what could happen if prices were to start rising again. As a result the benchmark cash-3s period ended last week valued at $58.00 contango, in from $61.25 the previous Friday. Further along the curve, the huge lending pressure of the previous weeks took something of a breather. But the shape of the curve continues to be a hot talking-point on the London “street”. As of Friday’s valuations, contango stretched all the way through the back end of 2008. The far-forwards played a bit of catch-up last week with Dec 2011 falling by $84—harder than 3-month prices for once. But open interest there and in 2009 and in 2010 remains high with big funds said to be battling it out and investment money still flowing into far-dated aluminium to bypass shorter-term volatility and shorter-term bear signals. This long-term shape-shifting in the curve looks set to be a feature of aluminium for some time to come. Shorter-term direction will come from outside—has the financial system stabilized after the intervention of the central banks?—and from inside—what happens if all those shorts are forced to start covering back? MI is taking a summer break between Aug 20 and 31. We’re back on Sep 3 and this item is back on Sep 10. Hope everyone’s tightly strapped in for the likely roller-coaster ride in the interim…