Metal derivative markets are in an unprecedented period of
change. Although one of the principal arguments for trading
commodities is that they are counter-cyclical, trading in them
has risen, even though they have become increasingly correlated
with other market indicators such as equity indices.
Does this mean that metals, like other commodities, will
lose their attraction for those who want to diversify their
portfolios? Or are they now perceived as a higher return asset
class, which will draw investors for the momentum play, not
caring if their investment is no longer so uncorrelated?
The link between metals and equity prices has grown
significantly over the past few years. Catherine Virga,
director of research at CPM Group, a commodities research and
asset management firm in New York, says the correlation
coefficient between the S&P 500 Index and the LME Index
grew from 0.19 in 2007 to 0.28 in 2008 and 0.58 in
The LME Index tracks prices in dollars of the six main
metals traded on the London Metal Exchange. The metals are
weighted according to global production volume and trading
liquidity, averaged over the past five years.
Market participants give two main reasons for the heightened
correlation. One is that, at the moment, the focus of metals
traders has switched from the supply side to the demand side,
as future demand is much more uncertain than in normal
Some believe that this trend is temporary and will become
less pronounced when the recession ends.
Steve Hardcastle, head of client services on Sucden
Financial’s industrial commodities desk in London,
says of the metals and equity markets: "At the surface level,
they’re correlated, because they’re
responding to the same announcements."
But he believes that, in normal times, markets tend to focus
on supply and demand figures. He says the present focus on the
demand side means commodities respond to similar announcements
as equities, but that after the recovery there will be more
attention to supply.
Telling the future
"It’s not surprising to see equities as a
driver," says Virga. "Since markets are moving on expectations
and gauging the future, one can expect it."
She adds: "The market is aware that demand will recover
quicker than supply can – it is pricing that in."
Another reason for the correlation is that increased
speculation in commodities means prices are affected by the
amount of leverage investors have, so there will be more buying
in good times and selling off when the market is less
Virga believes the correlation is partly being caused by the
trading patterns and models. "It’s not necessarily
temporary, but it’s momentum-driven," she says.
She doesn’t believe that this is necessarily
linked to the downturn. "It’s not necessarily
going to be at certain levels of the market [i.e. if
stockmarkets are above or below a certain level]
it’s whether it has the momentum behind it."
As with other commodity markets, the increase in the
proportion of metals trades executed by financial companies
such as investment funds and hedge funds has provoked debate
and some criticism. Lakshmi Mittal, chief executive of
steelmaker ArcelorMittal, was reported to have said that
financial institutions should not participate in metals
"A big feature [in the market] has been the impact of funds
and index investors," says Fred Demler, MF
Global’s head of global commodities, who estimates
that funds represent 70%-80% of the total volume. "That will
continue to grow as investors diversify their portfolios," he
Most market participants agree that funds’
presence will continue to grow. David Wilson, metals analyst at
Société Générale, says: "Investment
by funds is on the rise, especially with the advent of more
intelligent indices such as GSCI, which can be shorted as
Commodity trading is becoming increasingly common among
pension funds, as well as hedge funds. The way they trade
differs, though. One market source says: "Hedge funds tend to
be proactive but pension funds typically invest in commodities
via indices rather than directly."
Such a trend naturally prompts concerns that metals prices
may once again be building to artificially high levels, as
fluctuations in investment demand add to the volatility caused
by changing physical demand.
For example, commentators are divided as to how change in
interest rates may affect metals prices. The present low rates
make it much more difficult to get a decent return on bank
deposits or bonds. Commodities have offered comparatively
But when interest rates eventually rise, will commodities
therefore become less attractive? Against that view, by the
time rates rise, economies should be growing again, which is
likely to be bullish for metals.
The worry that investment money may be distorting the metals
market and masking real changes in supply and demand becomes
more acute when you reflect that all investors have to do to
make money is correctly predict when other investors are going
to move money into or out of the asset class.
"At pure fundamentals," Demler says, "metals are 50%-100%
overvalued. Index funds, long-only funds and ETNs are affecting
the price. The fundamentals are important for base metals but
so is the impact of these long-only funds."
Wilson has a similar view. "Fundamentals of last year
didn’t support a rally in copper prices," he says.
"People can argue that prices run ahead of fundamentals. Our
view is to look at fundamentals."
Whether these market conditions constitute a speculative
bubble, or could lead to one, is disputed. Even a market
minimally affected by speculation would be subject to
volatility, after all, as participants overreacted to changes
in supply and demand.
And changes in demand expectations are adding
volatility to today’s market.
From a fundamental perspective, Hardcastle says an upwards
overshoot on prices is possible because the market is taking
into account perceived supply shortages which may be less
severe than predicted.
"The least risk comes with commodities which do not
deteriorate and are not liable to short term extreme
fluctuation," he says.
Lavelle points out that there is a supply cushion in several
metals because at a certain price, mines with high operating
costs will be able to come on stream. "As prices go higher,
there is the opportunity to exploit previously unmined areas,"
Funds making long bets on commodities are not the only ones
adding a new dynamic to the market. As the proportion of
algorithmic trading activity in the equity and financial
derivatives markets continues to rise, the black boxes are
beginning to grow in prevalence in the metals markets, though
at a slower rate.
In fact, people point to them as the reason why the
proportion of LME trades executed electronically has risen
dramatically over the past decade.
Metals markets have resisted migrating to screens as fast as
other derivative markets. While the trading floors at many
global exchanges are now a shadow of their former selves, or in
many cases closed years ago, the LME’s Ring for
open outcry trading remains dynamic.
Nevertheless, electronic trading is growing – from
less than 1% of the LME’s volumes in 2002 to 19%
in 2009. One of the biggest reasons for this is algorithmic
Gavin Lavelle, chief executive of Brady, which provides
trading and risk management software to commodity markets,
says: "Growth in electronic trading has been spectacular.
It’s had a profound impact on how people
As a technology service provider to the electronic
market, Lavelle recognises the efficiencies this type of
trading can create. "It’s cheaper, faster and
easier to comply," he says.
Industrial companies using the metal markets have been
slower to go electronic than financial players, Lavelle says.
There are several possible reasons. Financial companies are
naturally better placed to trade electronically as there are
often synergies between their existing systems and processes
and the ones required to trade electronically on the LME.
Another reason, though, is that the LME’s Ring
remains the place where each day’s price is
discovered, and many do not feel the need to change the way it
Many say that because of this unusual set of circumstances,
the metals market has not yet been as affected as much as many
others by the black boxes proliferating in the market. That is
not to say that their presence has gone unnoticed.
"It’s created some quirky liquidity," says
Demler. He adds that although electronic trading has added an
element of liquidity, "most of it is coming from algo traders,
so is nominal liquidity".
Developments have also taken place in the back office.
LMESword, introduced earlier this year, replaced the previous
Sword system provided by LCH.Clearnet.
The system acts as a delivery allocation system, granting
warrants to firms with a net long position on the prompt date.
Though the LME acknowledges that price discovery takes place in
the Ring, it sees its electronic platform as important and
continually invests in it.
It is hardly surprising that, given its increasing
prominence and economic growth, China is the big story in
metals markets at the moment.
The Shanghai Futures Exchange’s volumes have
dwarfed those of the LME over the past few years. Now, the LME
is trying to fight back by entering into a collaborative
agreement with the Singapore Exchange.
The SGX will list mini versions of some of the
LME’s monthly metal futures, which will be
cash-settled against LME prices. The first four, subject to
regulatory approval, are likely to be copper, zinc, nickel and
Patrick McCormick, managing partner at World Steel
Dynamics in New Jersey, says collaboration between eastern and
western exchanges is "a mega-trend which is already on its way
and it’s going to continue". He believes this is a
good opportunity for the LME. "It would be great to be able to
tap that liquidity," he says.
Though Shanghai has swelled to a huge size in its domestic
isolation – foreigners are restricted from trading
there – when it comes to international trade, the LME
is still the hub.
The exchange’s dominant place in world metals
markets is increasingly being called into question because of
the growing interest in Asia. But, as Lavelle points out, it
may be harder for other exchanges to compete with the LME than
it is for them to challenge financial derivatives
"The key to the LME is it’s a physical market,"
Lavelle says, "and it needs warehousing to support its
business. That’s not easy to replicate."
(Photo by Paul Goyette)