MI WEEK IN REVIEW: Fear factor and rising LME stocks send aluminium reeling

In our summer break absence LME 3-month aluminium has fallen from $2,590/t (as at the close of Aug 10) to $2,447/t as of last Friday's close. In doing so it has punched out fresh 2007 lows and spent most of last week trading beneath the $2,500 level. The LME's most liquid contract has the closest correlation with other markets, in particular the US stock market, so it's no surprise to see the light metal suffering from the fear factor that has gripped the financial system in the last month. Panic That fear turned to outright panic on Aug 16—already dubbed by London locals "Black Thursday" due to the carnage seen across the LME complex. As the credit crunch transformed into a liquidity crisis, the likes of the yen and US Treasuries benefited and just about every other form of financial risk was the loser. Copper was the hardest hit by the combination of heavy fund liquidation and opportunistic selling from already short-positioned CTA systematic funds. But aluminium took its fair share of pain, 3-month metal sliding by $77 on the day to end valued at $2,470. Volumes were massive—across the board but particularly on aluminium—as trade buyers emerged in force to capitalise on the low prices. That helped support the light metal at the lows but it was really the US Fed's announcement the next day (Aug 17) that it was cutting its discount rate and easing lending terms to banks that steadied the markets. Panic reverted to fear and the fear factor has been in place ever since despite more periodic injections of liquidity by central banks into the financial system. Inter-bank lending rates are still super-high—evidence that the great and the good in the banking world are still wary of each other's balance sheets, fearing them punctured with black holes of non-priceable exposure to complex credit derivatives. Hedge funds have seen redemptions rise and several have shut up shop—most recently last week two commodity funds operated by Global Advisors. Any US company with exposure to the sub-prime mortgage sector—the origin of this global liquidity crisis—has seen its shares battered. The potential for further high-profile financial casualties seems to be viewed by the London "street" as a near certainty, keeping LME traders on high alert for the next financial squall to blow over the market from either the credit, stocks or banking worlds. Stocks That, however, is not in itself the whole story for aluminium. After the Fed's intervention on Aug 17, panic reverted to gnawing fear and most of the LME complex managed a partial recovery, helped by shorts taking their profits and trade buyers filling their boots. In aluminium's case this meant a bounce-back to $2,540 as of the close on Aug 31. Some of the more optimistic among London's locals were even talking about re-taking the $2,600 level, encouraged by the CTA community trimming back its huge collective short position from an estimated 95% of historic capacity on Aug 16 to around 85%. Last Monday's daily LME stocks report, however, put the market into a new tail-spin. LME inventories have been fairly directionless in recent months and it's been a long time since we saw any dramatic movement—in either direction—in any single day's report. Hence the shock that greeted the 15,100t inflow of metal reported last Monday. Most of it (13,100t) was warranted at Liverpool in the UK, which had quite a few locals scratching their heads in bemusement. With many US players absent due to the Labor Day holidays, local selling in London had aluminium rattling off $66 day-to-day to $2,478 at Monday's close. That stocks surge was the start of a broader surge with accelerated inflow switching to Baltimore over Monday-Thursday and then to Hull (also in the UK) on Friday. By the end of the week, LME stocks had risen by a net 39,000t and were at fresh 3-year highs. The source and motivation for this sudden influx of metal to LME warehouses remain obscure but the daily impact of large net increases undermined already fragile sentiment. The loss of the $2,500 level has had technicians of all shapes and sizes eyeing their charts—our own friends at Cliff Green Associates have cited the $2,400 level as the next major downside target. CTA "black box" players have wasted no time in flexing out their collective short position again—now estimated by our sources at 95% of historic capacity again. Flattened Equally obscure is the slugging match that has been taking place at the far end of aluminium's forward curve. Given the concentration of speculative interest on the far forwards, the recent financial market turmoil was always going to have implications for far-dated aluminium. Last Tuesday in particular saw a battle royal being fought out with locals speculating about forced liquidation and/or large positions changing hands. In these troubled times just about anything is possible. But the result has been a further flattening of an already flat forward market structure. Contango now stretches all the way through 2008 and as of Friday's close Dec 2012 at $2,296.50 was only $150.50 lower than cash metal.