Is Resurgent Dr. Copper About to Relapse?

A deeper look at the copper options market, however, shows a high degree of downside skewness as one moves away from at-the-money (ATM) options.  Out-of-the-money (OTM) put options on copper command much higher implied volatility premiums than similar OTM call options (Figure 3).  Moreover, in Q4 2017, copper’s implied volatility rose relative to its Q3 levels while implied volatility on options fell sharply for most other futures contracts (Figure 4).

What is the downside risk that copper traders are so worried about?  We think it can be summed up in two words: China and equities.  China’s economic stabilization in 2016 and 2017 after years of slowing growth was an unexpected and beneficial surprise for copper producers (Figure 5).  

Rather than cratering as many feared that it would in 2015, China’s growth rate improved in 2016 and 2017 as the Xi Jinping Administration stimulated the economy ahead of his successful bid to secure a second mandate.  Now, with the mandate in hand, the risk is that China’s economy will begin to slow under the pressure of a mountain of debt (Figure 6), a crackdown on lending growth and a broadening of the focus to include environmental concerns at the possible expense of growth.  

If China’s growth slows in 2018, as its yield curve suggests (Figures 7 and 8), copper prices have the potential to fall a long way, perhaps even retesting or breaking through their 2015 and 2016 lows. 

Equity markets pose another risk.  For the moment, global equity markets remain robust.  Some of the markets, however, have become quite pricey and as the world economy moves into a more advanced stage of recovery, the easy monetary policy that has supported the markets will probably come to an end. (See our papers on the VIX-Yield Curve, Credit Spread-Yield Curve and Unemployment-Yield Curve). 

That said, late stage equity bull markets can be quite powerful.  Stocks soared in 1988 and 1989, at end of the 1980s expansion.  They did they did even better during the late 1990s and also did well in the later stages of the 2003-2007 expansion.  As such, equities could continue to pull copper prices higher despite somewhat stretched valuation levels.

The good news for investors who might be concerned about how copper will perform in the event of an equity bear market is that the day-to-day correlation between copper and equity prices has been relatively low for the past few years; and were also not too high during the bear markets from 2000 to 2002 and 2007 to 2009. (Figure 9).  As such, even if U.S. equities sell off, they might not, to a large extent, negatively influence copper prices.   That said, if stocks continue to rally, they might also not be particularly supportive, especially if copper looks more to China than to the U.S. and Europe as a source of price support. 

If copper does sell off, watch for currencies such as the Australian dollar, the Brazilian real and the Chilean peso which in the past have correlated highly with copper, to find themselves under downward pressure.  Weaker emerging market currencies could also increase the downward pressure on China’s forex reserves and could eventually spark a devaluation of the renminbi.  This wouldn’t be due to lower copper prices but rather to lower Chinese economic growth which could send commodity prices downward and put emerging market currencies under pressure. 

• Copper prices and ATM options prices behave as if the global economy will continue to perform well.
• The skew on options betrays nervousness about downside potential in copper.
• If China slows in response to monetary tightening and high debt levels, copper prices could come under downward pressure.
• Equities pose some risk to copper but they aren’t always as highly correlated as one might expect.