Base metals prices confound expectations

After a week (Jan. 28-Feb. 1) which saw copper move from severe vulnerability to the strongest technical close in more than six months and aluminum climb above US$1,400 per tonne, the base metals complex should look solid and confident . . .

Supported by unexpectedly positive comments from the U.S. Federal Reserve, justified by a flow of strong, forward-looking macroeconomic data from the U.S., and driven by speculative funds eager to participate in what looks likely to be a solid recovery, prices should look poised to continue the upward moves of the report period to build a sustained, credible recovery . . .

Instead, prices still look vulnerable to disappointed selloffs as exposure to downside risks remains. In the immediate term, these risks stem from a lack of follow-through buying.

The positive U.S. data reinforced opinions that the American economy is undergoing a turnaround. For compelling evidence, we need look no farther than:

– the 2% month-over-month increase in durable good data for December 2001;

– the rise in consumer confidence in January 2002 to 97.3 from 94.6;

– the increase in the January National Association of Purchasing Managers’ index to 49.9 (the highest reading in a year and a half); and

– the surprising fall in the rate of unemployment.

Despite the increasingly positive economic outlook, downside risks in both copper and aluminum look set to remain a feature of the market over the near term. Although short covering is capable of quickly pushing prices above resistance areas, long liquidation by funds disappointed by the lack of follow-through buying could also reverse these gains with equal ease. As long as this remains the case, strong price gains in the metals markets should continue to look exposed to selloffs, and it is this risk that we see prices facing over the short term.

Although we have some doubts about the sustainability of copper prices at current levels, there is little doubt the situation has improved in the days leading up to presstime. Price support at US$1,520 per tonne has been reinforced after the holding back of additional price weakness earlier in the report period. Also, resistance at US$1,580 per tonne has been broken after three failed attempts during December 2001 and January 2002, pushing prices over US$1,600 per tonne for the first time since June of last year. Funds continue to exert the dominant influence on prices as consumer activity remains sparse. It is the dominance of funds in recent weeks that has caused us some difficulties in justifying price action since the start of the year, and even though recent data from the U.S. have been encouraging, there still seems insufficient evidence to argue that, at US$1,600 per tonne, copper prices are justified.

It’s easier to defend the view that price protection on the downside is at least increasing. Expectations of a strong first half have been reinforced by positive, forward-looking indicators from the U.S., and the ultra-cautious Federal Reserve has left rates unchanged, signalling, as its statement made clear, that “the outlook for economic recovery has become promising.” And yet, although we’ve recommended current prices as advantageous, forward-buying opportunities consumers remain reticent. With stocks still climbing (adding 25,000 tonnes during the report period) and indicators from Japan still weak, we suspect that fund-based gains will be hard to sustain.

It is equally difficult to place much credence in aluminum’s price moves. After initially shedding US$40 per tonne over two days’ trading at the start of the report period, by the end of the week, prices had reversed these losses in one day. Justifying such exaggerated price moves is difficult. The extent of these moves reflects the ambiguous and confused influences to which prices are currently exposed. On the upside, prices are buoyed by the improved economic outlook in the U.S., more encouraging price expectations in the rest of the base metals complex, and the continued closure of smelter capacity in the American northwest. However, until prices are pressured higher by concerted consumer buying, price increases — as the failure to remain above US$1,400 per tonne showed — should be difficult to sustain.

To a large extent, movements in the zinc price are mirroring those in the base metals complex. On Feb. 1, zinc climbed above resistance at US$807 per tonne to close at US$813. Earlier in the week, prices met scale-down buying at US$795-800 per tonne, and when this dried up, they met little support all the way down to US$780 per tonne. Regardless of the specific technical areas of support or resistance, it’s clear the zinc market still remains saddled with weak fundamentals. Furthermore, the slow and relatively mild response to the short-covering rally in copper and aluminum would indicate that the zinc market does not seem to have an excessive short bias. With fund activity acting as the main driver of prices in the current base metals complex, zinc may be unable to participate fully in any upward moves.

It was a comparatively lacklustre week for nickel, during which we witnessed a continuation of the trend of steadily increasing stocks and tests of support followed by tests of resistance. The peaks and troughs that affected copper and aluminum largely bypassed nickel as prices rarely moved below support at US$5,800 per tonne and never managed a test of resistance at US$6,050 per tonne. Having prevented further losses in the face of a weakening metals complex earlier in the week, support has been reinforced at US$5,800 per tonne. On the other hand, after the most equanimous price response to the rallies later in the week, resistance has also been reinforced at US$6,050 per tonne. In the light of this, how likely is it that prices will be able to break the technical levels of support and resistance that have prevented significant price moves from taking place for almost two weeks?

Given that we think copper and aluminum price increases are unsustainable at current levels, based on fund activity alone, nickel looks unlikely to receive much upward support from this area. As with zinc, it would appear that, based on price response to the latest short-covering rally, funds in nickel remain unnerved, indicating that, between US$5,800 and US$6,050 per tonne, the propensity of funds to hold fresh short positions has waned. More range-bound trading? As stocks climb higher and the cash-to-3-month backwardation eases, the risks should increasingly turn toward a test of support, especially when fundamentals are taken into account.

In generally quiet trading conditions, gold prices were able to build on early-in-the-week gains toward the end of trading on Feb. 1. After short-covering and stops were triggered toward the end of the week, prices tested resistance at US$284-285 per oz. to break the range and move over US$286 per oz.

We ascribe the initial increase to the sudden bout of equity weakness in U.S. markets. Confidence seems to have returned following the positive response to the Fed’s decision on interest rates, the subsequent statement, and the continued flow of encouraging macroeconomic data. The Dow recovered earlier losses, while the U.S. dollar looks even more firm against the euro and the Japanese yen. Although short-term flows of capital out of equities and away from the greenback may be reflected in mild spikes in the gold price, we do not see it as indicative of any significant long-term pattern. Indeed a comparison of equity movements against the gold price since the start of the fourth quarter of 2001 shows the strengths that have been made in the former, while the latter has made only grudging gains.

— The opinions presented are the author’s and do not necessarily represent those of the Barclays group.