Speculative forces in Chinese commodity futures are being allowed to run rampant

Photo by Zhong Zhi/Getty Images

The movements in Chinese bulk commodity and steel futures are now no longer massive, they’re downright crazy.

Anyone opening an account with a futures broker should be issued with a mandatory neck brace, such is the nature of the markets in 2016.

Fundamentals, much like the equally crazy boom-bust moves seen in Chinese stocks in 2014 and 2015, have seemingly been pushed to the wayside, replaced by a swirling sea of speculation in what was once a morbid, boring marketplace.

The moves seen in recent months are more akin to outright gambling rather than investing.

In what is quickly becoming the norm rather than the exception, steel futures, and the raw ingredients required to produce it including coking coal and iron ore, have been moving in lockstep.

Collectively, one day they get thumped, the next day they soar. They might as well be the one contract, rather than where individual commodity prices will sit in the future.

While fundamentals kicked off the rally earlier this year, underpinned by supply disruptions, curtailment of Chinese production and renewed infrastructure and residential construction, those earlier gains have seemingly enticed anyone looking to make a quick buck to become an instant commodities trader.

Just take the moves seen on Tuesday as an example of the degree of speculation that’s now in these markets.

Coke futures up 8.73% at the mid-session break. Coking coal up 7.63%, iron ore and rebar both up 6%.

In the previous sessions, these contracts had been pummeled.

These moves are also being played out in other markets with the Australian dollar and ASX 200 materials index both outperforming on the day, having been under pressure recently.

While fundamental factors have often been used to explain the wild moves, the honest answer is that they’re not being driven by fundamentals.

Inventory levels, steel margins, steel mill shutdowns and even Donald Trump’s mooted fiscal spending plans — they’ve all been used to explain the moves, but only after they have occurred.

The truth is that fundamental factors don’t change this quickly, or indeed several times a week which is seemingly the case in these markets.

We’re read a lot of research from some very smart people as to what’s driving these markets, but perhaps the best we’ve seen so far is a simple reason offered by Paul Hissey and Alexander Hislop, analysts at the Royal Bank of Canada.

In a note released earlier this week, the pair said that the wild gyrations in these contracts — often in the same direction — reflects the “financialisation” of bulk commodity futures in China, allowing for speculation, rather than fundamentals, to dictate price direction.

“(This) means daily prices become more removed from fundamentals,” they say.

“The continued maturity of futures markets for bulk commodities and reluctance to invest in other asset classes have at times pushed investors into commodities, when previously this avenue may not have been available.”

In other words, there’s a lack of alternative investments, and the recent introduction of commodity futures trading has seen swarms of punters enter what was a restricted marketplace.

Many, as was the case with the stock market rally and bust last year, are inexperienced investors.

When you have an abundance of capital looking for a home, a huge rally in prices to stir up interest and many inexperienced investors looking to capitalise, this is the end result.

Although market Chinese regulators have taken steps to address the wild swings, there’s more than enough evidence to suggest that more stringent measures are required.

As we saw in May this year when tighter trading restrictions were implemented in these contracts, it lead to a sharp and abrupt decline as speculative forces were curtailed.

Now that they’ve clearly returned, the clear risk is that a similar outcome will eventuate.

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